The technicals behind EM debt
The macro backdrop has always been a key driver for EM assets, but in recent times technicals have become just as crucial a determinant of investor sentiment.
The investable EM debt universe has changed beyond all recognition over the past 15 years, yet the evolution of the asset class remains underappreciated by many non-EM specialists. The new landscape provides important challenges, but also plenty of opportunities, and investors should not be deterred by outdated or misleading traditional concerns about EM.
What was once an inaccessible and opaque asset class, dominated by a homogeneous set of high-yield sovereign debt specialists, has grown into a sizeable and diverse EM asset universe. Today there are some $15trn of EM debt assets, representing 11% of total global securities. In the early days, EM debt was largely characterised by hard-currency sovereign debt, but the latter only represents less than 10% of the total outstanding now. Over the past decade in particular, there has been a surge in local-currency debt; a testament to the maturing and resilience of the asset class that has allowed sovereigns to move away from external financing and to lower perceived vulnerabilities related to borrowing in a foreign currency. This process has also been spurred on by rapid growth in local banks, insurers and pension funds across EM. Corporate debt issuance has also accelerated, especially over the last five years, with the total outstanding now more than twice as large as that of sovereign debt.
Naturally, the rapid growth of EM debt has given rise to some concerns about refinancing risks for the years ahead. Our own view is that, so far, one cannot conclude that EM has issued too much debt – in absolute terms the stock still appears manageable. Moreover, growing strategic buy-and-hold investments look set to enable continued refinancing in many cases and it is also worth noting that EM only relies on debt for 11% of its total financing.
A common misconception about EM debt has been the fear that capital inflow into the asset class is bound to reverse when yields in DM start to rise. We would be the first to acknowledge the risks from volatile capital flows during significant exogenous shocks. We firmly believe, however, that concerns about traditional “sudden stops” in capital inflows, as experienced by the EM of old, are no longer relevant today. The asset class now benefits from much more stable ownership patterns, thanks to a far more diverse universe of investors with varied risk profiles, objectives and investment time horizons.
In particular, the emergence of more passive investors has brought new trading strategies, which have contributed to more resilient holdings. Although this is often overlooked, buy-and-hold investors are playing an increasingly important role in determining the overall price action.
Buy-and-hold institutional investors, such as global pension funds and insurers, now account for a big share of the EM corporate credit market, with a skew towards investment-grade hard-currency corporate debt. Asian and other EM institutions play an important role in supporting local credit markets, as with Chinese state owned enterprises or banks in the Middle East. Meanwhile, the exit of some mutual funds from the EM debt asset class had been compensated for by the entry of central banks and sovereign wealth funds, which have gone on to play a similar anchoring role in local markets by pursuing their own needs for reserve diversification.
To be sure, active investors remain the key determinants of EM debt market trends, and they continue to exhibit high sensitivity to liquidity and mark-to-market considerations. Active investors are, however, less dominant than they were a few years ago and these days they appear to provide a different type of opportunity for investors to explore. Some 90% of EM dedicated investors are benchmarked, with around half focussed on hard-currency sovereign debt, which represents only 9% of the investable EM fixed-income universe. We believe it is only a question of time before these skewed investment patterns are adjusted. In our view, active investors remain both an important force for EM debt and also a source of potential upside for investors.
Another important technical concern about EM debt has been that, since the global financial crisis, market liquidity has decreased excessively, both for global fixed income and for EM in particular. Reduced bank trading activity, due to higher capital charges and the aforementioned surge of buy-and-hold investors, has undoubtedly made market liquidity conditions more challenging. However, a point that is often overlooked is that the market’s need for liquidity has also declined. Liquidity-rich pension funds and insurers have a long-term focus on income and are largely unaffected by the structural changes described above. Similarly, central banks and sovereign wealth funds have the ability to hold EM local assets through bouts of FX volatility, and for many of these investors potential realised EM FX losses are more than offset by USD gains.
The aforementioned combination of technical trends has resulted in a “clustering” of liquidity by market segment: hard-currency EM benchmarked funds tend to focus on sovereigns, quasi- sovereigns and large corporates only; while hedge funds have migrated towards derivatives, liquid sovereigns and quasi-sovereigns, and distressed credits. As a result, trading volumes in hard-currency and local market bonds have remained stable since the global financial crisis. In other words, despite all the regulatory and structural changes, there appears to have been no significant impact on active investors in EM debt, who seem to have adapted to the new liquidity environment. Adaptability is likely to be key going forward and we think it should be a top priority for any investors wishing to capture the attractive opportunities on offer across the rapidly evolving EM debt universe.
Ivailo Vesselinov is chief strategist at Finisterre Capital LLP, Damien Buchet is CIO of Total Return Strategy