30 June 2014Asset management analysis

Emerging market debt— an asset class for captives?

The fixed income investment environment in the developed world has been in an unusual state for an extended period of time. In the US, multiple rounds of what central bankers call quantitative easing, effected through purchases of treasury notes and agency mortgage-backed securities, have expanded the Fed’s balance sheet holdings to over $4 trillion. This has suppressed market yields in fixed income securities denominated in dollars across the maturity spectrum, with short-term treasury yields near zero and, in fact, deeply negative when adjusted for inflation.

In the eurozone, yields have similarly been pushed lower, not by explicit bond purchases by the European Central Bank, but by other acronym-laden programmes designed to keep European banks and sovereigns liquid and solvent. In this environment, income hungry and relatively conservative investors—captives included—have sought income-producing assets of all kinds, which in some cases has led to the consideration of investments in exotic asset classes that would never have been seriously contemplated as recently as 10 years ago.

One of the new asset classes being considered is emerging market debt. But is emerging market debt really an exotic asset class? The answer varies depending on what part of the emerging market debt universe you are considering and what you compare it to. First, however, we should discuss the term ‘emerging market’ and whether the moniker is still appropriate in 2014.

In previous post-war decades, it is fair to say that sovereign distress and sovereign bond defaults were concentrated in what were considered to be the emerging markets. Notwithstanding more recent localised defaults in the Caribbean and Latin America, the major stress periods in the emerging markets were a 1990s phenomenon, with episodes of default, currency devaluation and restructuring in Mexico, Russia and throughout East Asia in that decade.

In contrast, Greece, a developed market country within the eurozone, appears to have been able to declare itself insolvent, be downgraded to far below investment grade and subsequently default twice, yet avoid being thrown out of the club of developed markets. Examples such as Greece make designating emerging market assets a tricky prospect, with some emerging economies outperforming their more developed peers. Indeed, the lasting impression of the financial crisis in 2008 is that banking meltdowns in the developed markets can (and did) put the global economy into a far more precarious position than any previous difficulties in emerging markets.

Many market participants have had occasion to rethink which countries around the world should be in their investment universe.

Restricting the scope of the discussion to sovereign debt, and leaving aside the growing universe of corporate emerging market debt, there are two metrics that support a reassessment of credit fundamentals and what belongs in investors’ crosshairs across the developed and emerging markets.

The first metric is the fiscal health and fundamental macroeconomic picture of the countries that comprise the global debt landscape. As recently as 2001, emerging markets represented approximately 20 percent of global GDP, but differentials in growth rates between developed and emerging economies have most recently put the emerging market share of global GDP at greater than 40 percent, with at least half of that spectacular difference coming since 2008.

Better institutional discipline in the fields of governance, political structures and monetary policy have been important steps here, but the one area that has changed starkly, in terms of relative strength, is the difference between emerging and developed market fiscal positions as measured by government debt as a percentage of GDP (also known as the debt-to-GDP ratio). According to the IMF, the fiscal position of developed market economies has deteriorated substantially from 2007 to 2013, moving from an average debt to GDP of 74 percent in 2007 to the current average of 104 percent.

Special note could also be made of the US’s figure at 103 percent, Italy’s at 132 percent and Japan’s at a whopping 243 percent. Over the same period, average debt to GDP in the emerging markets has been almost unchanged: 34.7 percent in 2007 and 34.9 percent in 2013. The same phenomenon exists in annual primary budget data where, on average, budget deficits in the emerging markets are half of what they are in developed economies. What this tells us is that faster growth and good balance sheet management in the emerging markets, coupled with sluggish growth and very high government debt issuance in developed markets, has made emerging markets a much more attractive place to invest.

The second metric that has led to broader acceptance of emerging market sovereign debt is actually a lagging indicator (one nonetheless important to institutional investors in bond markets): credit ratings. In 1993, almost none of the emerging market debt universe was investment grade. Today, the overwhelming majority of the local currency emerging market debt universe is investment grade, as those sovereign issuers that have developed a deep and liquid capital market for their home currency-denominated government debt tend to be the stronger of emerging market issuers.

The market for local currency government and corporate debt is one of the fastest growing capital markets globally. More than 25 percent of total emerging market local currency debt issuers are AA-rated, a fact that is not well known by new investors to this market. The picture is similar in hard currency emerging market debt (mostly dollar-denominated), but the percentage of non-investment grade issuers is slightly higher in that market and in terms of global market capitalisation, hard currency debt is a shrinking percentage of the emerging market universe.

If you’ve read this far and are ready to say ‘Sounds great, where do I sign up?’ the following is the section you’ll want to read about the risk/reward balance of investing in emerging market debt. The low yield environment in the world’s developed markets and the relatively better fundamental trends in the sovereign countries that comprise the emerging market debt universe have not gone unnoticed by the investment community. Over the past 18 years, performance in both dollar and local currency denominated debt has been very strong, with total returns outperforming even developed market equities, with a lower standard deviation in most years.

Typical arguments for inclusion of the asset class in a broader portfolio tend to rest heavily on the premise that, over time, the better return, lower correlation and decreasing volatility of the asset class make it a good addition. We would caution, however, that credit spreads (what an investor gets paid to take incremental credit or currency risk in emerging market debt) have been declining since before the credit crisis period and at the time of writing were near record lows. Additionally, the total absolute yield, particularly dollar-denominated sovereign debt, is also near a record low. At the time of writing that all-in yield was 4.5 percent, so in an environment where both emerging market sovereign credit spreads are historically low and US Treasury yields remain suppressed, the chances of seeing any of the double digit-type returns of previous years in the asset class are slim.

This is a classic example of why past performance is not necessarily a good predictor of future returns. For those captives that have primarily been invested in the short to intermediate-term investment grade bond market, comparisons regarding risk and return might not be particularly relevant. Investment grade corporate bonds, as a whole have, for example, experienced annualised volatility at about one quarter of what emerging market debt has experienced over the modern era of dollar-denominated issuance. Academic research has confirmed that the past higher returns have been correlated with increased risk, as one would intuitively expect.

In conclusion, we are supporters of the idea that the classification of what is considered an emerging market versus a developed market is increasingly blurry. For captive owners who can understand the risk/reward trade-offs in purchasing emerging market debt, it can still be a valuable way to add diversification and some incremental yield to a conservative portfolio.