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Magazine Issues » December 2010

EM DEBT: selecting the right manager

manager_selection_410Institutional investors must ensure their emerging market debt manager is equipped with appropriate local expertise, advises Mathias Neidert, at bfinance

With the sovereign debt crisis in Europe, emerging market debt (EMD) has increasingly come under the radar of institutional investors who are rethinking their bond diversification strategy. Not only have emerging market economies continued to post positive growth despite the crisis (2.4% in 2009, according to the IMF), but their borrowing also remains relatively limited compared to developed countries. According to the Bank for International Settlements, emerging market countries are issuing less than one-quarter of global sovereign debt while contributing to one-third of global economic output.

Historically, pioneers of emerging market debt investing were sophisticated investors considering EMD as an alternative investment with absolute return objectives. EMD now also presents itself as a more mainstream asset class that can be introduced into long-only fixed income portfolios as a diversifier. However, EMD is a generic asset class that encompasses various sub-markets with different risk and return profiles. A usual way to characterise emerging market debt is to distinguish between external debt denominated in so-called hard currencies (eg US dollar, euro) and local debt denominated in the national currencies of emerging countries.

A rapid look at the genesis of the emerging debt market helps to grasp its current structure.

Twenty years ago, governments of emerging countries were facing debt denominated in hard currencies (mainly the US dollar). From the abandonment of currency pegs in the late 1990s, those governments started issuing bonds in their own national currencies. Since then the global stock of such local currency debt has grown at a faster rate to now represent, in US dollar terms, more than three times the stock of external debt. Moreover the local debt market has seen yield curves extending through the issuance of longer dated bonds. Those developments are mainly explained by the demand of local pension funds and by the desire of governments on the offer side to reduce the volatility of the value of their debt following fluctuations of their national currency.

External debt is not directly affected by movements in the local yield curve and behaves much like a “yield + spread” asset class, remunerating investors for the default risk of emerging countries on top of the US treasury yield. On the other hand local debt entails exposure to local yield curves and foreign exchange rates on top of the credit risk. This constitutes a potential for value and diversification, albeit with additional volatility that can be detrimental to investors domiciled in developed countries. Over the five-year period to September 2010, the local currency bond index JP Morgan GBI-EM Global Diversified yielded, in US dollar terms, 20.1% on an annualised basis with a volatility of 11.9%. Over the same period the hard currency bond index from JP Morgan (JP Morgan EMBI Global Diversified) returned 14.3% annualised with a volatility of 9.5%. As per the potential for diversification, external debt and local debt had relatively low correlations of respectively 0.30 and 0.16 with global aggregate bonds. That comes at the cost of higher correlation with the emerging equity market, at 0.69 for external debt and 0.80 for local debt.

Those characteristics are nowadays well understood by institutions contemplating  externalising the management of their emerging market debt portfolio. We now commonly see institutional mandates purposely blending hard and local currency debt with a ratio of 70:30 or even 50:50. Data gathered for a recent bfinance search for an EMD manager showed that the median manager investing in hard currency with an allowance of up to 10% local debt outperformed its benchmark by 1.50% on an annualised basis over a period of five years to the end of 2009. On the other hand the median manager investing from 10% to 50% in local debt outperformed by 1.85% over the same period. It is worth noting, however, that the risk-adjusted return (as measured by the information ratio) of this latter group was lower (0.49 against 0.72 for managers with less than 10% local debt) due to a larger increase in tracking error. Their volatility also increased significantly.

Hence selecting a manager for a blend mandate throws down further challenges. Institutions contemplating the externalising of an EMD blend mandate need to ensure from a rather qualitative point of view that the management team can properly address the additional risks through appropriate expertise. Local debt managers must be equipped with the right amount of resources and experience in order to efficiently comprehend local monetary policies and foreign exchange dynamics and in turn correctly position their portfolios to capitalise on the opportunities.

Mathias Neidert is senior associate, research and development, at bfinance

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