22nd May 2013
Shaun Port, CIO at Nutmeg.com discusses the four types of emerging market debt for Mindful Money below.
Many investors are well aware of stock market opportunities in developing economies – so-called Emerging Markets. EM equity funds are always found in the top 10 best-selling lists of funds with private investors, despite considerable underperformance in EM equities compared to developed markets.
However, many private investors are unaware of the opportunities in bonds issued in emerging economies, both by governments and companies. Once regarded as an extremely speculative investment – particularly after several episodes of EM countries defaulting on debt – EM bonds are now widely accepted as an asset class with interesting benefits – and particular risks.
The key reason behind the increased interest in EM debt is the improving credit worthiness of EM countries – both in absolute terms and, in particular, compared to the deteriorating finances of developed market governments. Eighteen countries in developing economies are now rated as “investment grade” by Standard & Poor’s[i]. In general, EM debt offers better prospective returns as a pay-off for the higher risk – and higher frequency – of default.
Another key risk with many EM bonds is the risk of a sharp fall in the value of a currency as a result of market stress (eg credit crisis) or a particular event in any one country (e.g. political uncertainty). The returns from EM bonds are driven by different economic and market factors to bonds in the developed world, so offer diversification benefits.
EM bonds come in four flavours from a wide range of countries:
1) External (‘hard currency’) debt involves bonds issued in currencies such as the US dollar or euro. This is commonly the first debt to be issued by a government to tap overseas sources of finance. Hard currency EM debt was created in 1989 when the debt of countries which had defaulted in the 1980s was converted in external currencies – so called “Brady-bonds”. More recently the external debt market has a growing presence of what is known as “frontier” markets. For example, in April 2013 Rwanda issued its first external bond, borrowing $400million over 10 years, paying 6.625 per cent per annum. Issuing debt in an external currency means that investors are relatively unconcerned by domestic emerging market inflation and changes in local exchange rates. They are principally concerned about whether a government can finance debt repayments – or will become unwilling to do so.
2) As financial markets develop, governments issue Local currency government debt – bonds in their own currency such as Brazilian Real. While the majority of governments issued short-term debt (Treasury “bills”), in many economies the local market in longer-dated bonds (e.g. 10 years to maturity) is under-developed and demand is weak. As these domestic markets find new buyers (e.g. local pension funds) the depth of available issues improves. Investors in EM local bonds are exposed to changes in government policy – particularly with regards to government borrowing, inflation, interest rates and the exchange rate. More recently, changes in exchange rates have provided the greatest source of volatility for investors. As such, an investor in local government debt not only judges whether the bonds are a good investment, but also whether it is worthwhile investing in the currency.
3) Once a local debt market is established, governments may choose to issue inflation-linked debt – i.e. bonds where the regular interest payment and the final maturity value are linked to inflation. The EM inflation-linked bond market is currently dominated by five countries – Brazil, Mexico, Israel, Turkey and South Africa – but bonds are also available from Korea, Thailand and Poland. Investors in EM index-linked debt are much less concerned with rising inflation (normally good for index-linked bonds) but are exposed to currency risk.
4) Companies in emerging economies also issue corporate debt as the market in government debt becomes firmly established (to provide a benchmark for risk in that country). This is often issued by state or part-state owned companies and therefore entails both government and corporate risks.
EM bonds are a very useful asset class to include in investment portfolios, enabling reinvestment, through exchange-traded funds in these four EM debt markets. Each offer different risks and potential returns. As these markets grow they will become an increasingly important area for investors – particularly given that the massive amount of government debt already issued in developed markets currently offers paltry returns.