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Magazine Issues » July-August 2012

EMERGING MARKET BONDS: A rocky road paved with gold

winding roadInvesting in emerging market debt for the first time brings the challenge of how to access the asset class before its potential rewards are reaped, finds Nick Fitzpatrick.

So you accepted the bad news of miserable investment prospects for the developed world and at the same time fund managers won you over with their emerging market growth story.

Now, as an investor still invested predominantly in European equities and bonds, you realise that if the professionals are right, your portfolio is drastically off course from the strategy you need if you are to not let down fund beneficiaries.

But once embarked upon, how perilous is the road that leads the investor into an emerging markets portfolio? What happens once they leave the more familiar political, tax and market-infrastructure climates of Europe?

There is a good chance that a first, meaningful allocation to emerging markets will be through local currency bonds. This asset class has been one of the most sought-after investments in the emerging market segment with investors seeking higher yields and additional potential returns from escalating currency values.

Yet this asset class has also displayed that the emerging economies – even those among the holy quaternity of the Brics (Brazil, Russia, India, China) – still have a whiff of the frontier about them. Witness Brazil, where from March this year the authorities introduced a 6% tax on local currency bonds with maturities of less than five years. This capital control did what it was meant to do and devalued the Brazilian real which international investors had pushed up as they bought reales to fund bond purchases.

It’s a challenge for local debt markets in the emerging world to absorb inflows and the Brazilian authorities, like other governments, are wary of the adverse impact that yield-hungry foreign capital could have on their currency and economy.

Capital controls of this nature are a hazard that emerging market investors have to be wary of and, along with other operational difficulties, they are a consideration for investors who are deciding whether to access the emerging market story through a segregated mandate (if they can afford one), or through a pooled fund.

This is the first question to be asked once an investor has decided to make a direct commitment to the emerging geographies.

Nick Greenwood, pensions manager at the Royal County of Berkshire Pension Fund, a UK local authority scheme with around £1.5 billion (€1.8 billion) under management, says the benefit of a segregated mandate is a tighter focus on the investments the investor needs. But the set-up can be complicated, while the pooled-fund alternative delivers a ready-made vehicle that should be able to deal with events such as capital controls and other irregular occurrences.

“A segregated mandate will allow you to more tightly focus your investments – but you may have to confront issues such as taxation on income and capital controls on large incoming investments yourself. This tends to direct investors more towards a pooled fund.”

Highly visible
The Berkshire Pension Fund is invested in the emerging markets through pooled funds with five asset managers – but not in local currency debt. Greenwood says the fund sold off its local currency emerging market debt portfolio earlier this year, feeling the risk-reward equation was no longer favourable. But the pension scheme’s stance on the emerging market story is still reflected in its larger weighting to emerging market equities than developed market equities.

Emerging market debt has become a highly visible asset class since at least 2010 when the strongest UK trend in manager search activity was for emerging market equity and debt, according to research by Mercers, an investment consultancy. Total emerging market searches increased from one emerging market equity search in 2009 to 23 debt and 13 equity searches in 2010.

Meanwhile, the market in emerging market domestic bonds went from $1 trillion in the mid-1990s to more than $5 trillion in 2011.

However, these figures are not reflected in major index sources. Many of the bonds are not traded regularly enough or have some other drawback that prevents them from entering indices. The capitalisation of JP Morgan’s emerging market indices is just $2.38 trillion and of that, bonds issued in local currency rather than dollars accounted for 62% as at February 2012, which translates into $1.48 trillion.

The segregated route to these bonds comes with complications that can take weeks to resolve.

Greenwood adds: “Even if you think it’s a well established market, accessing it on a segregated basis can be difficult. With the emerging markets, there is a minefield of sub-custody accounts to open.”

David Dowsett, senior portfolio manager at BlueBay Asset Management, a fixed income specialist, says: “Local currency bonds… must settle in the local market, unlike hard currency bonds. This means you need custodian relationships and it can take two to three months to set up those relationships in 20 large emerging market countries.”

The issue of settlement in local currencies is further reflected by Claudia Calich, head of emerging markets at Invesco Fixed Income.

“Some emerging market local currency [bonds] may not be settled through Euroclear, so you would need a local account in the country itself,” Calich says. Euroclear currently settles securities in 52 currencies.

This is where custodians come in once more, but even they may differ over what currencies they consider restricted.

At the other end of the spectrum from settlement, merely buying bonds can be hard. Indian local currency debt illustrates the point. Rob Drijkoningen, global head of emerging markets debt at ING Investment Management, says: “International investors are not allowed access to the domestic bond market unless they go the Mauritius QFII [qualified foreign institutional investor] or Singapore QFII route which also eliminates or reduces capital gains tax and withholding tax.”

Capital gains tax is 10% for long-term bonds and over 20% for short-term bonds. Withholding tax is 15%.

Drijkoningen adds: “International investors are allowed to bid via auctions to be able to participate in the domestic markets in small amounts only, but not via Mauritius… [They are] thus still hampered by withholding tax and/or capital gains tax which are applicable to corporate and government bonds.”

Nevertheless, the benefit of the segregated mandate is that the investors who are large enough to run one in the emerging markets are more likely to obtain the investments they want and to avoid those they don’t want. The latter point is important because it might not always be obvious which bonds, or indeed equities, should be avoided.

A particular irony
Greenwood says: “The very big emerging market companies are not necessarily exposed to emerging market growth, like Petrobras in Brazil.”

Petrobras is a Brazilian energy firm, one of the largest companies in emerging markets, with a presence in 27 countries. There is a good chance that a very index-aware strategy or pooled fund owns it.

Zsolt Papp, emerging market fixed income product specialist at Geneva-based bank and asset manager UBP, says: “It can be a problem if an investor picks a company that is part of a benchmark, because these companies can grow to such a size where they have more links with the developed world.”

He cites another example: Gazprom, a Russian company that is the biggest exporter of gas to Western Europe.

So a particular irony exists if investors have sought emerging market exposure specifically to risk-manage problems associated with Europe and end up with European exposure through the back door. There is the potential for this to happen as perceptions of risk change throughout the eurozone crisis.

“Over the past year, some investors have had to go into emerging markets from the eurozone just to meet their risk objectives,” says Papp.

The road to emerging market gains can be a difficult one, but no doubt many investors will travel it in the years to come.

If you do decide to take this road, make sure it’s worth it.

As Greenwood says: “Do not be beguiled by emerging markets. Not all of them are growth stories.”

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