EM debt survey − from alternative to mainstream asset

A year when fund managers built country-specific investment strategies upon the structural argument for global economic rebalancing; and when EMD went from a high yield alternative to a legitimate asset class in its own right. 

In a November survey of 168 investment professionals, 96% were favourable to emerging markets, and 69% were encouraging their investors to increase their allocation, according to the Barings Investment Barometer. 

As the new kids come on the scene, the older ones are taking stock. 

In a schemeXpert.com  survey of leading EMD fund managers, 62% of respondents said they expected 7-9% returns this year. 

The most bullish range predicted was 13-15% returns, and none saw returns falling lower than the 4-6% bracket. 

Jerome Booth, head of research at Ashmore, says he expects dollar sovereign debt to rally this year, regardless of where the spread is. “The spread is not really a binding relationship,” he says. 

This year will see a further “broadening” of the investor base, he adds, from insurance companies to corporate treasuries putting cash balances into emerging debt. 

Last week, global financial information company Markit launched a new set of benchmark and tradable indices for dollar denominated EMD. 

It said the Markit iBoxx USD Emerging Markets Sovereigns group had been introduced in response to “increased investor interest in emerging market debt”. 

The right kind of debt?   

Local currency debt was chosen as the best type of debt for pension funds by 54% of respondents. 

One asset manager said a dollar denominated debt fund was “overly dependent on the path for US rates”, whereas local currency debt has a “broad global exposure” with opportunity for added return from appreciating currency. 

A further 38% said both local currency and dollar-denominated debt held together was the correct approach for the institutional investor. 

Advocating a “diversified strategy” across both asset classes, one asset manager said: “We believe that local has the better long-term potential but many pension funds have liabilities more tied to the dollar denominated debt.” 

Spin the globe

Russia was the biggest country allocation in four EMD funds, followed by South Africa and Mexico with the biggest allocation in three funds each, and Brazil in two. 

“We have a large weighting in Russia 2030 bonds, which tend to be a highly liquid proxy for the overall market,” said Damien Buchet, head of emerging market fixed income at Axa Investment Managers. 

Buchet said Argentina (a yield of 7.94%, according to Markit) and Venezuela (14.14%) are the Axa fund’s biggest active bets against the benchmark. 

He added: “They are reflective of our tilt towards high yielding, high beta credits, but with a view that these tend to be less correlated to global market woes and US interest rates risk.” 

Pick a risk

Asked for the biggest risk to face the asset class this year, 46% answered inflation risk. A further 15% opted for the related interest rate, or duration risk.

Taking a different tack, 15% said risks generated in developed economies posed the greatest threat to the asset class.

Choosing inflation as the biggest risk, one respondent speculated that the “pace of tightening” in emerging markets could withdraw liquidity at a rate which lowers global risk appetite.

An EMD-specific challenge is defined by another respondent as “liquidity reversal risk”. Newcomers piling in without a proper understanding of emerging market volatility and “sporadic” crises could be swift to desert. The respondent added: “Weak hands could leave the boat quickly.”

Softly, softly?

“Structurally, obviously we’re quite bullish over the next number of years,” says Colm McDonagh, head of emerging markets, fixed income, at Insight Investment.

But 2011 is going to be different from the last couple of years, he adds, where overarching investment principles could provide returns.

A variety of economic drivers need to be recognised, including the cost of money in the developed economies rising to a point at which EMD becomes overly expensive, and valuations have to adjust.

“Over the past few years there’s been quite an attractive return, and reasonably low volatility,” says McDonagh. “A number of people are assuming that will carry for the next couple of years. We are not sure it is going to be as linear as that.”

Others see opportunities for the EMD investor to go further – one option is corporate debt, issued in US dollars, which Booth sees as a natural complement to dollar-denominated government debt.

“Not many people do corporate debt,” he says. “But when you ask them three years ago, they wouldn’t have done local currency debt either.”

As long as EMD is maturing, opportunity will remain constant for the investor, whether that means fresh country allocations or alternative forms of debt.

But as the party becomes more crowded, managers agree returns will require equal attention to country-specific duration, liquidity and inflation risks as to the global economy.

If the managers want continuing attention from pension funds, the structural argument alone is not enough.