April 2010

INSIDE VIEW: Emerging market debt

Emerging markets can still offer good investment opportunities, in spite of their strong rally last year, writes Mark Pearce of Threadneedle... 

fruit.jpgEmerging markets were among the strongest performing equities of 2009, easily surpassing global markets. The robust nature of these stocks has focused investors’ attention on the investment opportunities available in several countries in the developing world. We believe there is one area that those wishing to gain exposure to these fast-developing economies may be overlooking: emerging market debt.

The economic fundamentals in many emerging markets have improved markedly over the past decade. Moreover, the emerging market debt sector contains a diverse range of investment opportunities – from higher quality and sovereign bonds to a growing number of corporate issuers. Critically, although emerging market debt markets performed very well in 2009, we believe the asset class still offers attractive yields and spreads in relation to the developed world. In particular, hard currency emerging market debt provides an attractive level of carry in comparison to US treasuries and money markets, and we have found significant opportunities among local currency emerging market debt.

Improving fundamentals
The governments of many emerging economies are now in a stronger financial position than their counterparts in, for example, the US or Europe. Significant fiscal deficits have become common across the developed world, as governments injected money to help prevent a prolonged economic slowdown. However, the story in the emerging world could not be more different. Emerging markets are net creditors to the world, and public finances are set to improve as these economies shake off the effects of the global financial crisis. In fact, no emerging market government has defaulted on its debt as a result of the current economic slowdown.

Furthermore, again in marked contrast to the developed world, emerging market banks are well financed and their economies are at a different stage of the credit cycle. In the 1980s and 1990s, the financial problems experienced by some emerging markets were triggered by domestic conditions. As a result, emerging market governments were forced to improve their economic and monetary management and restructure their banking systems. This led to the resilience emerging markets are now showing in the face of broader global economic uncertainty.

In the longer term, the growth potential of emerging economies is much greater than that of countries in the developed world. Consumer debt levels in most emerging economies are low, while, in the developed world, there are rising concerns that high levels of indebtedness could drag down the growth of advanced economies for some time to come. Developing economies also benefit from better demographics than their more mature counterparts, the latter typically characterised by ageing populations and increasing dependency ratios. Furthermore, countries in the emerging world are investing heavily in infrastructure and technology, allowing them to improve productivity (a key driver of economic growth) and helping emerging market companies compete ever more effectively against established global firms.

The information available to analysts on the finances of emerging market economies has improved significantly over the past ten years. The major rating agencies monitor the creditworthiness of governments in the asset class, while finance ministries and central banks now publish a great deal of data and analysis. Moreover, the International Monetary Fund, the World Bank and the Organisation for Economic Cooperation and Development (OECD) issue numerous reports. Consequently, it is possible to conduct fundamental economic analysis with greater confidence than was the case in the past when there was less transparency and reliable data was scarce.

Yield spreads tightening
Emerging markets are attracting greater levels of investor interest, reflecting improved economic management and greater transparency, as well as the backing of organisations such as the OECD. Developing countries such as Poland, Hungary and Mexico are OECD members, whilst others including Brazil, China, India and Russia are poised to join or are co-operating closely with the OECD.

These developments are creating opportunities for investors, given that yield spreads over US treasuries typically tighten when a country appears on track to join the organisation. As a result, where a country like Brazil might once have had to pay significantly higher interest rates on loans than the US, for example, this is no longer the case. Investors are demanding a much lower yield premium, with positive implications on pricing for existing bonds. Furthermore, we believe that the same trend of narrowing spreads will continue to characterise emerging market economies in coming years.

We expect narrowing spreads to apply in particular to those countries where investors are still demanding relatively high risk premiums. This group includes countries that were impacted by the recent global financial crisis and where their governments are now taking major steps to develop and strengthen the local economy. This includes emerging market economies such as Hungary, Mexico, Russia and Turkey. Although these countries may not be benefiting from the massive capital flows that have flooded into other emerging economies, such as Brazil, we believe the ongoing efforts to drive economic stability and strength will lead to rising asset bond prices and falling yields.

Local currency bonds
Rising investor interest is also creating emerging market currency appreciation, which many analysts believe will be a major global trend in 2010 and in subsequent years. Although local currency debt is a relatively new sector, investors in sovereign and quasi-sovereign bonds issued in local currencies can benefit by exploiting pricing inefficiencies that often arise between the local currency and hard currency denominations of similar bonds issued by the same body.

Yields in the US and the eurozone are very low and are likely to remain so for some time, as central banks adopt very loose monetary policies to spur their debt-burdened economies. By contrast, yields in many emerging economies are much higher, reflecting higher local interest rates and the strength of local economies. In December 2009, for example, the average official interest rate in the developed world amounted to 0.5%. By comparison, the rate among emerging economies was 4.5% and in Latin America it stood at 5.7%. We expect this interest rate differential to support emerging market currencies in 2010.

Further opportunities exist in countries where the market is mispricing risk. Venezuela is a good example, with markets demanding a risk premium for investing in Venezuela that is not justified by economic fundamentals. Investors appear wary of the political environment in the country and in particular of President Hugo Chavez. However, the country has met all of its debt obligations, is a net creditor and has sizeable foreign exchange reserves. While recent currency movements have caused concern, our analysis suggests the political risk has been overstated. We believe it is crucial to evaluate political risk alongside economic analysis and, in doing so, we can uncover new investment potential.

We believe that emerging market bonds hold considerable opportunities for investors in 2010, following the firm gains made by the asset class in 2009. Many still offer a highly attractive carry and benefit from strong and improving economic fundamentals. Other incentives include the potential for currency appreciation – and the subsequent gains to be made by investing in local currency bonds – as well as mispricing in other areas of the market. These opportunities can be exploited by a fund manager who has a solid understanding of both economic fundamentals and political risk.

• Mark Pearce is a fixed income investment specialist at Threadneedle

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