Emerging markets (EM) are smartening up to prudent fiscal policy and closing the gap with traditional ‘safe havens’, according to a report from research firm Clearpath Analysis.
The Investing in Emerging Market Currencies and Debt 2013 report explores investors’ strategic shift to EM debt and currency exposure and their departure from the European bond market. With contributions from Lazard Asset Management, Aberdeen Asset Management, First State Investments, Pioneer Investments and institutional investors including Railpen Investments and Second Swedish National Pension Fund, it questions whether dollar-denominated or local currency best protect returns.
Investors are anticipating the greatest growth in Asia, but with Mexican and Brazilian currencies performing well, the opportunities for lifting investment returns appear endless.
Trevor Williams, chief economist, Lloyds Bank Commercial Banking Group, predicts that in 2013 the emerging economies will continue to outperform, growing by close to 5.7% from 5.2% in 2012. In contrast advanced economies will remain the laggards, with annual growth on average of around 1.3%.
The positioning of EM currencies and debt within any portfolio carries a diverse risk/return composition as well as complex macroeconomic factors and so investors are taking various stances. Denise Simon, managing director, portfolio manager/analyst, Lazard Asset Management, comments: “We see volatility on the hard currency credit side at around 5-6%, where on the local side it is around 10-15%.”
“German investors have been investing in emerging market debt for a long time, and they probably have 15-20% of strategic allocations,” she added. “(By contrast) the UK and U.S lie somewhere in the middle with between 0-5%” strategic allocations.”
So with some investors already ahead, what opportunities exist in emerging market corporate bonds?
Greg Saichin, head of Emerging Market and High Yield, Pioneer Investments, notes the Emerging Market sovereign benchmark offers investors a 4.5% dollar return, versus the Corporate benchmark at 5%. “The appeal of corporate does not end with simple income. Spreads are more attractive, offering 315 basis points over treasuries to sovereign’s 260.”
Even if Emerging Markets are only approximately half weighted, relative to their contribution to global GDP, a rebalancing of allocations to global corporate bonds could see significant support to further deepen this market, he added.
Aberdeen Asset Management is also offering a blended approach where investments can be made “across the broader EM debt asset class” for maximised investment opportunities. Some 75% of the corporates that issue in dollars from the emerging markets are investment grade, the firm noted. “This is a defensive place for investors looking to get some incremental pick-up in a low yield environment for credit.”
According to Brett Diment, head of Emerging Market Debt: “If you look at where Brazilian 10-year US dollar bonds trade currently, they trade at a spread of 100 basis points over US Treasuries. Ten years ago it was very difficult for any corporate in Brazil to issue when the sovereign was trading 800-900 basis points over Treasuries.”
In contrast, Lithuania has taken a very successful approach to fiscal consolidation and managed to get its fiscal deficit down from 10% of GDP in 2009 to below 3% GDP.
In support of the blended approach Diment states: “It really plays to have the flexibility to invest across the opportunity set and often the opportunities arise in different segments of the asset class.”
Despite growing interest in local currencies there is still support for hard currencies that perform consistently. Manuel Canas, senior portfolio manager, First State Investments, says local currency debt offers a better risk-return profile. “By contrast, sovereign hard currency debt is an asset class that has matured and, if anything, it’s shrinking. This year, I am expecting net issuance to fall below $10 billion and this is conforming to a decreasing trend given the $19 billion net issuance last year.”
“Out of the 4.70% yield that you get, 280 basis points come from spreads, which is a very high proportion of the total returns,” he explains. “I fully adhere to the view that there is more room to converge from a credit rating perspective between emerging markets and the core markets. I feel the 280 basis points you get in terms of spread is an attractive proposition.”
Frederik Rast, portfolio manager, Industriens Pension, argues that despite increasing the emerging market allocation from 7.5% to approximately 10%, dollar denominated currencies are still the better risk-return profile. Even though bonds have been around for some time, “local currency has been a bit trickier for us and more volatile, but we have been able to find managers who have generated alpha”.