March 2010

FIXED INCOME: the new sovereign rule

Emerging market debt managers believe any contagion from Greece will hit developed markets rather than developing ones, finds Fiona Rintoul
king.jpgI give you one word: Greece.

We can argue about what caused the Greek crisis. “They basically lied,” says one commentator. “The requisite fiscal discipline was absent,” opines another more soberly. And we can argue about what will happen next. A sovereign default cannot, at the time of writing, be ruled out – but a less dramatic outcome is more likely.

“In theory, an EU member facing a sharp rise in borrowing costs and insufficient investor demand at bond auctions could respond by trying to renegotiate its debt obligations or even leave the eurozone,” says Andrew Milligan, head of global strategy at Standard Life Investments. “We think the probability of either is very low. It would not be to the economic advantage of the eurozone member. The cost would be considerable, including, for example, a fall in the value of the ‘new’ national currency, higher imported inflation and interest rates, or an outflow of capital.”

There can, however, be no argument as to whether the Greek crisis changes things. It does. But in all the talk of contagion spreading out from Greece, the traditional view that emerging markets would suffer in such circumstances has changed and debt managers now expect the opposite. Rather than hinting at any vulnerability in emerging market debt, Greece highlights vulnerabilities in the developed debt markets – and if there is contagion that’s where managers expect to find it.

The emerging markets, even those that looked vulnerable, such as Hungary and the Ukraine, have held up well, says Kevin Daly, emerging market debt portfolio manager at Aberdeen Asset Management. In the Ukraine, for example, the market has shrugged off political concerns surrounding the recent election.

“In the old days, there would have been a sell-off,” says Daly. “These markets have become more mature in terms of how they respond to political developments. [emerging market debt] is becoming a more mature asset class. There are isolated instances of political risk in the asset class, but for the most part one should be more concerned about what’s happening in the developed world.”

Emerging story
What Greece tells us, then, suggests Christopher Wyke, product manager at Schroders’ emerging market debt fund, is that Michael Milken’s comment that there is no such thing as investment-grade corporate bonds – just corporate corporate bonds that pay high interest and corporate bonds that pay low interest – could equally be applied to sovereign debt.

“Emerging markets look far stronger than developed countries,” says Wyke, “but for some reason they give you a higher yield.”

Certainly, the emerging markets story as told in figures is a compelling one. Emerging markets have 85% of the world’s population and 50% of its growth at purchasing power parity. They have have high savings ratios and a fraction of the developed world’s indebtedness at all levels of society: government, corporate and private.

“Emerging markets have much stronger balance sheets and as a result they were able to withstand the worst crisis since the Depression and came out of it better than the developed world,” says Daly.

For the concerned bond investor, the most important consideration is perhaps this. “All countries are risky,” says Jerome Booth, head of research at Ashmore, an emerging market specialist, “but in emerging markets it’s priced in whereas in developed markets it isn’t. The bond markets that don’t work are the ones in developed countries. They don’t reflect political risk.”

Despite Iceland, despite Greece – both developed markets – there is a kind of collective blindness at play that stops people seeing the comparative risk in developed and emerging markets clearly, suggests Booth. This is because the world is clinging on to a quasi-colonial view of the global economy that no longer holds true.

“Managers have a core/periphery view. They think the core [developed markets] affects the periphery [emerging markets], but the periphery doesn’t affect the core.”

That view is just so ‘old world order’. In the new order, emerging markets are going to dominate production and consumption. They are going to have most of the growth. “Like all the growth if we have a recession,” says Booth – and what happens in the so-called periphery is going to affect what happens in the so-called core.

Green shoots or whitewash?
There’s something else too. In addition to the well-documented problems the developed world has already experienced, there is something a little bit puffy and, well, desperate about the way developed-world monetary authorities are proceeding at the moment – even though there may be no other choice. There’s a lot of talk of green shoots, but are there any actual shoots of a verdant hue? Do the monetary authorities even think there are?

“Monetary authorities have flooded markets with money to try and convince them of something they may not believe themselves,” says Booth. “The Greek episode was a wake-up call. It should be used in a positive way to help people rethink their portfolios.”

Or, as Wyke puts it: “If a bond has a triple-A rating, it can only be downgraded.”

What does that mean? Should bond investors give up on developed markets and look at the higher-yielding emerging markets, which now also look safer?

For Booth, it means moving towards a situation where asset allocation reflects emerging markets’ 50% share of global growth. A have-a-try 10% in emerging markets is nowhere near enough.

“Emerging markets shouldn’t be a little bit on the side,” he says. “Investors in developed markets risk a massive jolt when it all comes to pieces. You really don’t want to be invested in Europe or the US at the
moment. We need to rethink our perception of the world.”

And, as Schroders’ Wyke points out, we are in a market environment where investors could lose money on bonds and investors’ tolerance for losing money in bonds is less than in equities. Wyke has seen many people get into his funds who have never invested in emerging market debt before.

“A year ago you could have bought credit,” says Wyke, “but all the low-hanging fruit has been picked. The attraction of emerging-market debt is that it’s not a one-trick pony. You can look at external and local debt or currencies.”

Others, such as Daly, are perhaps a little more cautious. Booth puts the total investable emerging market debt universe at $8 trillion (€5.86 trillion), compared with a $7 trillion US Treasury market.

Note of caution
“It’s safe to say that investors should increase their exposure to emerging market debt,” says Daly. “But there’s only so much emerging market debt you can buy before you’re buying too much.”

Investors want liquidity and they want exposure to deeper markets, says Daly. The lion’s share of their bond investments is therefore to remain in the bigger markets.

There’s also the risk of another episode like 1998. Daly says: “The problems we have now are not an emerging market concern, but if we have a flight to quality, for example if Greece deteriorates and there are concerns about the viability of the euro, then there will be a flight into dollar Treasuries.”

And even if you consider the case for making a substantial allocation to emerging market debt to be irrefutable, there’s inertia to consider.

“The shift is already taking place,” says Daly. “Consultants are making all the right noises to us that they really like the emerging market debt story and that’s trickling down to their clients. But these pension funds are like supertankers. It will take time.”

Also important is how investors go into emerging market debt. Despite all the positive talk from emerging market debt managers, everyone agrees that it’s not an asset class where you can pile in willy-nilly and expect to do well.

“Whether you are investing in the emerging or the developed markets you need to do your research,” says Wyke. “You shouldn’t rely on rating agencies.”

The idea that you could buy beta is also a nonsense in the current environment where ‘the shock’ hasn’t happened yet.

“The fact that G7 and G10 government bonds are unattractive makes emerging market debt look safer, but you need to be selective,” says Wyke. “We see most opportunities in Asia. Bond markets such as Indonesia are very attractive. Central and Eastern Europe might move through later in the year. Markets such as Hungary are very attractive and still undervalued. But it’s not a buy-and-hold market. You need to be active.”

©2010 funds europe

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