July-August 2013

EMERGING MARKET DEBT: The not-so-Great Rotation

Spinning topsInvestors have started to pull money out of bond funds as concerns mount that US, Japanese and Chinese monetary policy will tighten soon. Stefanie Eschenbacher takes a closer look at the emerging market debt sector. Recent fund flow statistics have given further impetus to the debate of a Great Rotation whereby assets are allocated away from fixed income to equities. Bond funds were hit by net outflows of $23.3 billion (€18.4 billion) in the third week of June, provisional data from EPFR Global, a data provider, suggests, smashing the record of $14.5 billion set in the previous week. Particularly affected have been emerging market bond funds with hard currency mandates. Even previously resilient emerging market corporate bond funds suffered outflows. In mid-June, Ben Bernanke, the chairman of the US Federal Reserve, finally confirmed what markets had anticipated for some time: that the US asset purchasing programme is likely to slow down later this year. EPFR notes that Bernanke’s remarks dashed hopes the Fed will move slowly when it comes to ending the third round of quantitative easing. Around the same time, the Japanese prime minister, Shinzo Abe, also made a public statement from which speculators concluded there was going to be less aggressive monetary stimulus than initially expected. Robert Horrocks, chief investment officer at Matthews Asia, says the situation has been further exacerbated by spikes in interbank rates in China. Those spikes, he says, are a sign of the government cracking down on domestic liquidity in an attempt to rein in credit growth. “While this tightening may be desirable, its timing couldn’t have been worse, given the comments from the US and Japan,” Horrocks says. “Speculators sold everything – bonds, equities, gold, and bought US dollars.” THE SEARCH FOR YIELD
Robert M Hall is an institutional fixed income portfolio manager at MFS Investment management, which manages the MFS Meridian Funds Emerging Markets Debt Fund, one of the oldest and largest available to European investors. “The asset classes that have been the biggest beneficiaries of quantitative easing will feel the negative effect of its end the most,” says Hall, of emerging market debt, equities and high yield bonds. Once liquidity is reversed and rates normalise, he says, many investors who have invested in emerging market debt because of the low yields on developed market debt will take their money out of emerging market funds. The assumption is that they will put it back into developed market funds because they will be able to get the same yield but take less risk. Hall says a fair amount of normalisation of treasury rates has now been priced into the market with the double-digit decline in emerging market debt in May and June. “There is a notion that emerging market debt is not as risky as once perceived, but I would not want to suggest that emerging market debt is risk-free,” Hall says. “It is certainly not.” While Hall says emerging countries tend to have stronger balance sheets than developed countries, there is always the question of political risk. “We have seen that in Turkey and Venezuela,” he says, hinting at the recent protests in Turkey and the bumpy leadership transition in Venezuela. Massive amounts of liquidity created by major banks – the Fed, the Bank of England, the European Central Bank and, more recently, the Bank of Japan – had initially benefited emerging markets. Monetary policy had compressed yields to a point where investors were no longer able to meet income and yield targets. Their search for income and yield had ended, more often than not, in emerging markets. Lorenzo Naranjo, an assistant professor of finance at ESSEC Business School, says markets have been extremely sensitive to comments about tapering in recent months. While a dramatic switch is unlikely, he says central banks will eventually have to rethink their policies. This is the case not only for the Fed but also for the European Central Bank, the Bank of Japan and others that have tried to fight economic decline with massive stimulus packages. “Most central banks now have big balance sheets and hold a lot of debt,” he says. “But the mandates of these banks are not designed to put in place such measures.” Naranjo says while some money has gone back to central banks in the form of deposits, investors really look for good returns and want to invest where the economy works and where there is “real growth”. Rob Drijkoningen, global co-head of emerging market debt at Neuberger Berman, says the discussion has certainly caused “unsettling” effects in emerging markets. TAPERING
While year-to-date inflows are still strong, Drijkoningen concedes the tapering discussion has gained traction among investors and interest in emerging market debt has weakened. “Most emerging markets are still in easing mode from a central bank point of view,” he says, adding that corporates have fared far better than sovereigns.   Drijkoningen has recently increased weights in countries such as Brazil, Mexico and Peru. Up until the end of last year, Drijkoningen and his team were also overweight Venezuela and Argentina. While macroeconomic policy in the West is a factor to consider, there are many others. Drijkoningen says Venezuela is adjusting to slower growth prospects and Nicolás Maduro has had a “weak mandate” since he took over as president after Hugo Chávez died this March. Drijkoningen says Maduro has a low degree of support and will have to navigate a “very chaotic country”. In the meantime, he has closed the underweight after a substantial widening of spreads on these bonds. Because of the Venezuelan government involvement in certain sectors, particularly the oil sector, corporates are sometimes a proxy to sovereign risk. Petróleos de Venezuela, a major state-owned oil corporate is such an example. Nine months ago Hall started to increase the allocation to corporates in the portfolio based on the compelling risk/reward potential. At the end of September last year, he held 12% in corporate bonds. This share has now increased to 20%. “There are certainly a lot of opportunities and issuances in the corporate space,” he says. From the beginning of 2012 to the end of May 2013, emerging market corporates have issued over $500 billion (€391.6 billion) in debt. To put this into context, it is almost the market capitalisation of the Emerging Market Bond Index Global, which tracks returns of all traded emerging market debt. “But there is a tremendous need to be selective,” he adds. Hall’s asset allocation calls look similar to those of Drijkoningen. He has started to underweight the large investment grade bonds of Brazil, Colombia and Mexico. SOVEREIGNS
Over the past two years, spreads on those bonds versus treasuries began to narrow until recently. The Mexican dollar-denominated sovereign bond for ten years, for example, trades at 140 basis points over ten-year treasuries. For investment grade emerging corporates, this spread is now 270 basis points. Hall says that where he sold sovereigns, he bought sovereigns within the same country. Guillermo Osses, head of global emerging market debt at HSBC Global Asset Management, says asset allocation has become more tactical and his team has moved cash levels up or down more agressively, depending on the opportunities in the market. Osses says in a total return strategy he is benchmark-agnostic and tries to capture the best opportunities. At the end of March, net investments were 30%. The remainder was not necessarily held in cash, but in near-cash investments that are neutral in terms of risk. Today, net investments are in excess of 80%, with 72% in hard currency-denominated positions and another 10% in long currency positions. “In the past, we used to be a lot more gradual when we made allocations,” he says. “Now we are more risk-averse and more tactical.” Osses and his team tend to focus corporate exposure in stronger BB ratings with good quality. He warns that what people underappreciate is the withholding taxes of up to 20% that incur when buying local currency denominated corporate debt. This is common in almost all countries for investors based in the US or Europe, and Osses says it is “high enough to make it difficult for local corporate bond markets do develop”. He adds that while there are opportunities in high yield debt, mandates often put a constraint on the manager. The market has matured and it has become easier to outperform the benchmark by reducing credit quality and put money into higher yielding debt. “Emerging market debt as an asset class is still evolving,” Hall says. “Over time, the breadth of opportunities within this asset class will grow.” Naranjo says emerging markets have become more transparent. “Emerging markets realised that what they need to make investors confident is a rule of law, such as property laws,” he says. “They have made a great effort to make investors feel protected.” FLUCTUATIONS
Data for such movements is often not immediately available or based on estimates. Though Naranjo says there has definitely been a sell-down in recent weeks, the developments are a far cry from the Asian crisis, for example. At that time, he says, “from one day to the next”, investors started selling down emerging markets – regardless of their location. “Emerging markets know this all too well,” he says of the recent risk aversity. “If you are an emerging market, it doesn’t matter if you’re in South America or Asia. It is the same with Spanish companies; it doesn’t matter if you are profitable or not, you are Spanish.” He says such fluctuations are the reason many emerging markets have imposed investment restrictions. Despite the recent perceived rotation, Naranjo says there is so much money invested in emerging markets these days that it would be hard to pull it all out. Ed Moisson, head of UK and cross-border research at Lipper, shares this line. He says the sheer scale of inflows to bond funds – particularly in global, high yield, emerging market and flexible funds – in recent years means it would take many more months for allocations to be rotated. ©2013 funds europe

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