Chaos. Meltdown. Global crisis. Collapse of capitalism. These are just some of the words and being used to describe the extraordinary turmoil in international financial markets in recent weeks.
Across all asset classes there has been a sharp exodus from anything that looks vaguely suspicious in terms of credit quality—even if the underlying credit is actually sound. Around the world, the high-grade debt market has virtually disappeared. Only the best-quality issuers can find investors.
In the flight from risk, emerging markets have been hit – hard. The fear is the simple: contagion. If the US and the rest of the developed world move into recession, these markets will fall with the rest of them; because they are emerging markets, their fall will be more precipitous than the developed world.
Holding local currency emerging market debt has proved increasingly popular over recent years – credit crunch, toxic mortgages and the rest aside – has been a new and exciting trend for investors. So its undoing would come as a shock to many.
But despite the global market turmoil, the facts underlying the local debt asset class are more mundane. In recent months, a number of UK pension funds have put out mandates for local currency emerging market debt, says Paul Timlin, head of operations, client services and sales outside the US, at Stone Harbor Investment Partners. With the UK market seen as among the most conservative of European institutional investors, this has hammered home the fact that emerging local debt is going mainstream.
LONG WAY TO GO
But if this is a trend, it still has a long way to go as, despite comprising 13–15% of the total global debt markets, according to Peter Marber, head of GEM fixed income and currencies at HSBC Halbis, most investors still have less than 5%.
Still, investment consultancy Watson Wyatt, does not recommend investors holding more than a few per cent despite seeing emerging market local currency debt as an attractive asset class, according to Margaret Frost, global head of bonds. “Emerging market debt [EMD] is a return seeking strategy, it does not match liabilities. For pension funds, it is one of many return-seeking assets, so the allocation should be fairly small. I would imagine local currency debt might be 3-4% in total.”
In the long run, local currency is clearly an asset class whose importance will grow, but the short-term outlook is far less certain. And many fund managers have cut their exposure to local currency in recent weeks on the back of a weakening of commodity prices and the strengthening of the dollar.
John Cleary, managing director of Focus Capital, said the dollar strengthening was a surprise that led the firm to sell off most of their local currency emerging market debt exposure earlier this year. “The dollar strength surprised us and undermined a lot of the local currency stories,” he says.
Payden & Rygel had as much as 40% of its emerging market debt exposure in the past in local currency but are now down to 20%, with no plans to increase this at the moment according to fund manager Christina Panait. “We had local currency bonds comprising as much as 40% of the total but are now down to 20% and we are not planning to add to this at the moment, but will do so opportunistically,” she says.
Pioneer Funds had a peak of 17% of their emerging market mandates in local currency debt but started reducing exposure last year and are down to 6–7% according to fund manager Yerlan Sysdykov. “Right now,” he says, “with increasing inflationary pressures and the volatility seen in financial markets, appreciating currencies such as Russia and Indonesia are no longer so attractive in terms of their risk/return trade-off as strategies for generating outperformance.”
Western Asset Management is not investing at all in local currency right now, according to Michael Story, a representative of the investment firm, both because of their negative view of the macroeconomic environment, but also because their own clients and prospects are not yet comfortable with local currency bonds. With volatile financial markets and correlations across asset classes increasing dramatically, Story says they are holding off from adding any risky assets, which would include local currency bonds.
CHANGING ATTITUDES
Nevertheless, increasing interest in local currency bonds by institutional investors such as US and UK pension funds reflects changing attitudes in recent years to emerging market debt.
Emerging market debt has generated extraordinary returns in the past – the composition of emerging market indexes has changed from being around 10% investment grade seven years ago to over 50% nowadays.
The wake-up call for emerging market debt investors was in 2005. Up till then, high-yield and emerging market debt were often mentioned in the same breath. But then General Motors and Ford were downgraded to junk bond status, flooding the high-yield market with their debt, yet there was no contagion in the emerging market debt space, which outperformed.
Emerging market debt has also held up much better than emerging market equities and US credit. HSBC Halbis’ figures on debt returns in the year to July 2008 show that US high yield gave a negative return of 2.1%, while emerging market hard currency investments returned 5.1%, but local currency emerging market debt returned 13.7% – comfortably beating the return on US Treasuries at 10.3% (and despite the flight to safety there by investors fleeing from the collapsing asset-backed debt market).
Long-term institutional investors need to look beyond the short-term economic environment to decide on their asset allocations, and there seems to be plenty of evidence that local currency bonds will find a niche within institutional portfolios.
In a completely unconstrained world, Mn Services, the Dutch-based fiduciary manager with $7 billion in emerging market debt, would have a 50/50 split between hard currency and soft currency debt, according to fund manager Salman Saif.
Stone Harbor launched a local currency Dublin domiciled institutional mutual fund in October 2007 and raised $500 million in just a few months.
Western’s Story says: “In the future, once the external environment improves, local currency debt will offer value, and this is not just a cyclical phenomenon but a secular trend of rising commodity prices and rising emerging market currencies.”
INFLATION FOCUS
Inflation rapidly became a key focus for the global markets and policy-makers alike in the second quarter of 2008, as oil and food prices spiked sharply. The subsequent policy response to inflationary pressures has differentiated the more attractive emerging markets from the less, in the eyes of investors.
Latin American countries such as Brazil and Mexico raised rates proactively to curb the price spikes while in contrast Asian countries such as Indonesia and the Philippines have been more complacent, allowing appreciating currencies to take the strain in combating inflation.
Russia has fallen in the latter category, but as Pioneer’s Sysdykov argues, an appreciating currency is a very poor instrument to control inflation, as a lot of it is structural in nature. “The Russian government has not been very successful in controlling inflation,” he says. “They tried to set prize freezes, but this does not work in the long term – and just leads to the disappearance of products from the marketplace.”
As a result, interest rates are being hiked aggressively to eradicate any lingering tendency towards hyperinflation, a fear that still haunts the emerging markets.
Other emerging European markets such as Poland and Hungary are converging towards the euro-denominated bond markets leading to a situation analogous with that of Italy and Spain during the 1990s, whose government bond spreads tightened in anticipation of adoption of the euro.
BRING YOUR BULLWHIP
But it is not just the economic and market views that are an issue for managing local currency debt. “You need to be a bit like Indiana Jones with local currencies and to bring your bullwhip with you,” says Marber at HSBC Halbis.
The problem is simply the rawness of these new markets. The infrastructure is still being developed, and in many cases, trading systems do not exist and problematic issues for foreign investors include custody, foreign exchange, withholding taxes and, most of all, the underlying liquidity of the marketplace. Moreover, the development of liquid local sovereign yield curves is a prerequisite for the development of local currency bond markets, given that local corporate issuers need a reference point to price their bonds.
As yet, the local corporate bond markets have not developed broadly or deeply enough to attract significant foreign interest, but it is likely that as liquidity improves, this will change.
Emerging markets more generally are themselves at different stages of development: fully developed emerging debt markets; frontier markets; and the underdeveloped ones that are still impossible for investors to reach.
“For hard currencies, most of the market developments have already occurred,” says Marber, “but Mexico did not even have a 10-year bond three years ago.”
The World Bank is encouraging the development of local bond markets through its year-old Gemloc (Global Emerging Markets Local Currency Bond) programme. This is being done in collaboration with Pimco, which develops and manages investment strategies that should promote institutional investment. This incorporates a local currency index that takes a broader and more inclusive view of the emerging market investment universe, including frontier markets.
The index-linked market is also developing as a number of countries have now issued bonds. In Brazil, the index-linked market is more liquid than the nominal bond markets, and now Chile, Colombia, Mexico and Poland have index-linked bond markets, while Turkey issued an index-linked bond last year.
THE SEARCH FOR LIQUIDITY
Liquidity is clearly the primary requirement for investors in local currency bonds. For HSBC Halbis, no country should be too daunting – so long as the market is large and liquid, political considerations are less relevant, says Marber. But generating liquidity requires a number of factors including private property, law and securities laws; SEC type regulators; local and international investors, research and a working operational environment.
Moreover, if a market maker can support a product, it will attract far more interest, so it is helpful if a country issuing bonds has a market-making strategy.
Institutional investors seeking to invest in local currency debt still have the task of selecting the best fund managers to do this for them. Local currency sovereign debt requires a skill set of views on the government bond yield curve, inflation, real yields, currency and the actions of central banks.
Traditional fixed income fund managers focusing on G7 or even G20 countries can be out of their depth when it comes to tackling the emerging market debt universe. “Investors need to ensure that their fund managers are not just benefiting from a play on a weak dollar. When the dollar rose recently, a lot of money was lost on local currency funds,” says Watson Wyatt’s Frost.
To be able to adopt strategies that can take advantage of widely different sets of circumstances and policy reactions across 30 or more countries means the management of emerging market local currency debt will remain a specialist strategy. “There are a handful of managers who are skilled, and a number of others with a solid infrastructure who we would not rate so highly,” says Frost. “If a lot of other managers jump on the bandwagon, it will mean they will have to poach good staff from elsewhere, which is always a problem.”