WILL OSWALD: More EM bonds buyers than you think
This decade is likely to herald the coming of age of emerging market bonds as logical recipients of global capital
To paraphrase Mark Twain, reports of the death of emerging bond markets have been greatly exaggerated. From the trough of the Global Financial Crisis in March 2009 until May of this year, dedicated emerging market (EM) bond funds saw $87 billion of inflows an unprecedented scale of interest in these markets. Outflows since then have reached almost 10% of this figure in just four months.
Faced with such evidence, it is tempting to believe that interest in EM local bond markets in recent years has been due to two factors: sustained economic growth in emerging markets compared with very low growth in developed markets; and a global rotation from equities into fixed income, aided by ultra-easy monetary policy in developed markets. Both factors are clearly cyclical in nature and appear to be reversing. Yet, there is enough evidence to suggest that the recent reversal does not signal the end of global demand for EM local-currency fixed income. The drivers of the rise of EM bond markets are more structural.
Our more constructive perspective comes from our unique on-the-ground analysis of both foreign investors and domestic savings pools in Standard Chartereds markets as we have explained in detail in our recently published Local Markets Compendium. Two years ago, the first edition of the Compendium published the first-ever dataset looking at domestic savings across more than 70 countries. One of the main revelations from this compilation was that domestic non-bank financial institutions (NBFIs), such as pension funds, insurance companies and mutual funds, are growing faster than underlying income in these economies.
Today, these large pools of domestic savings have become more important as the pace of foreign demand for EM bonds slows. This stands in contrast to developed markets. Such domestic pools of savings are viewed as a source of risk to bond markets as the increased allocation towards fixed income seen over the past five to six years is rebalanced towards equities. In the emerging markets, allocations towards fixed income remain at historical lows. With these new pools of savings in emerging markets representing a bigger share of world savings (life insurance premia rising from 9% of the global total 10 years ago to 19% today and pension assets rising from 3% to 8%), their asset-allocation decisions are likely to have important implications globally.
The EM domestic savings pools are set to become larger sources of demand for domestic government debt than before. For demand to materialize, though, a greater willingness to buy must emerge. Our study, for instance, shows a clear relationship between the steady decline in real yields over the past few years and the lower holdings of bonds within insurance company portfolios. The rise in real yields in emerging markets since May then represents an opportunity to mobilize demand from these large portfolios. This intersection of real yields and current allocations should bring further opportunities as interest rates rise over the medium to longer term.
The scale of reduced foreign interest in EM bonds will partly determine the gap that the NBFIs need to fill.
However, characterizing foreign demand for EM bonds as predominantly cyclical in nature a temporary safe-haven switch out of developed markets and out of equities in the aftermath of the 2007-08 financial crisis ignores the structural underweight in global portfolios that started this process. GDP-weighted indices are still relatively new tools in asset-allocation strategies, yet market capitalization-weighted approaches for global bond allocations have exposed investors to deteriorating sovereign credit in developed markets.
A too infrequently asked question is who is a typical foreign investor? This catch-all term hides significant variation. However, if we do not know who these investors are, we fail to understand the problems they face, and hence, it becomes more difficult still to determine how they will behave in the future.
Dedicated EM bond funds are the most widely tracked component of foreign investors, and indeed their growth over the past few years has been impressive. Yet, they represent less than half of all foreign investors.
Understanding which markets are more biased towards dedicated EM funds as a source of foreign demand is an important first step, one where we now have unique insights. For the first time, we are able to understand who the other foreign participants are and what their behavioural patterns are likely to be.
Global bond funds have become increasingly important participants in emerging markets. However, the newest and perhaps the most important participants are central banks and sovereign wealth funds. Historically, their allocations were through dedicated EM bond funds, but as these markets have grown in importance, so has their decision to internalize expertise. These new entrants are by no means short-term investors. Instead, they are reallocating with a longer-term strategy to reflect the multi-polar world of the new global trade corridors. This would imply not only that their current allocations are likely to stay, but that they will continue to rise as well.
If the first decade of this century was about the increasingly ascendant role of emerging markets in global trade, this decade is likely to herald the coming of age of the EM bond markets as logical recipients of global capital to reflect this economic shift. Seen in this light, any talk of the demise of the EM bond markets would not only be exaggerated but also is one of the surest ways to miss a long-term investment opportunity.
Will Oswald is Global Head of Fixed Income, Currencies and Commodities Research at Standard Chartered Bank