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Hedge Fund Monthly

Emerging Market Debt: A New, and Improving, Asset Class
Paul Luke, Chairman, Convivo Capital Management Limited

June 2004

Emerging Market Bonds

Emerging market debt has only become a recognised asset class for fund managers in the last 15 years. Although emerging markets (formerly called developing countries) have always relied on foreign debt to develop, it has traditionally taken the form of trade finance or syndicated bank loans. Ironically, the current market, which we estimate to be around US$1,500 billion in size, was born out of the huge defaults on sovereign bank debt during the 1980s. Mexico, Brazil, Poland and Argentina, amongst others, were obliged to default on their sovereign bank loans, which were floating rate at a time when the US Fed was hiking interest rates to historically unprecedented levels. In 1989, backed by the US Treasury, Mexico persuaded its bank creditors to accept a reduction in the principal they were owed, in return for long dated bonds with US Treasury collateral (so-called Brady bonds). Other sovereign followed suit. A number of fund mangers began to hold these bonds and an asset class was born.

The existence of Brady bonds, which were big, liquid issues, formed the basis for a switch by emerging market borrowers from bank finance to bond finance. Through the 1990s, most emerging countries resorted to bond finance. There are now about US$500 billion of emerging market Brady and sovereign eurobonds out-standing. On top of this, there are about US$100 billion of corporate issues. These bonds are well-researched by the big investment banks who offer good liquidity, easily as good as that offered in the US corporate high yield market. A full array of indices has been created, to allow managers to assess their performance in managing the asset class.

Local Currency Fixed Income

Meanwhile, another important sub-market has grown even more rapidly: local currency fixed income. Again, the origins of this market hark back to the 1980s sovereign debt crises. The International Monetary Fund supported most of the sovereign debt restructurings that occurred then, but did so on the condition that these countries improve their macro-economic behaviour and implemented structural reforms, including the establishment of local capital markets. Governments and local banks created increasingly liquid local treasury and commercial bill markets, helping to reduce reliance on foreign debt. The global local currency emerging fixed income market now aggregates to at least US$900 billion and offers abundant liquidity and the usual spread of derivatives that are available in G7 markets.

Key Qualities of the Asset Class

Aside from the liquidity and transparency offered by the asset class, there are several key features that make it attractive;

a) Credit improvement

Since the 1980s, emerging market borrowers have improved their credit-worthiness. True, there have been crises: Mexico in 1994/5, Asia in 1997, Russia in 1998 and Argentina in 2001. But an important point to remember is that in all the above cases except Argentina, no country defaulted on their eurobonds. Even Russia kept paying. Rather than get into arrears on their external bonds, most countries simply improved their financial discipline, using multilateral and bilateral finance to tide themselves over while they tightened fiscal policy and deepened structural reforms. The post-crisis improvements have been so dramatic that over half of the JP Morgan emerging market bond index is investment grade, including Mexico and Russia. The bias towards credit upgrades in the asset class means that emerging market external bonds have been one of the best performing asset classes in the world. If you had "bought the index" ten years ago, you would have trebled your money.

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Chart 1. Performance of emerging market bonds

Source: JP Morgan

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b) Greater reliance on foreign direct investment and local markets

It is an interesting point that emerging market borrowers have, on the whole, been cutting their foreign debt relative to exports. Indeed, many have become net lenders rather than net borrowers, with countries like China, Russia and Brazil building up their international reserves and deploying the bulk of them in US Treasury bills. Economic reform and an opening up of these economies has tempted foreign companies to invest directly in these markets, which has tended to cut the amount of external debt issuance. That, combined with a deepening of local capital markets, meant that external debt ratios are improving.

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Chart 2. Debt ratios are improving

Source: IIF

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c) Attractive yields still available

Despite the 14-year bull run in emerging markets debt, there are still some attractive yields available. Although the gap has narrowed, many emerging market issuers trade cheaper than G7 credits with the same credit rating. For example, as at the end of April, bonds of Turanalem, a Kazakstan bank with a Baa3 credit rating, were trading with a spread of 390 basis points over US Treasuries, while France Telecom, with the same credit rating, was trading with a spread of 190 basis points. In local markets like Turkey and Brazil, local currency yields of (respectively) 26% and 16% are still available, more than twice the rate of inflation in these countries.

d) The investor universe

Although the earliest players in this market were primarily leveraged speculators and bank proprietary books, over the years longer term institutional investors, especially pension funds, have entered the market, attracted by the high yields and improving credit quality that the market offers. These investors are not "jumpy" and mean that the level of market volatility has fallen dramatically.

The Outlook

We expect "more of the same" in emerging market debt, with upgrades exceeding downgrades and countries continuing to expand their local markets and keep external borrowing levels modest. That being said, there is no doubt that we are coming to the end of the US monetary/credit cycle and a move to higher US rates could impact emerging market debt spreads. Index and index-plus funds will do less well in this environment than funds that can raise cash or go short. Nevertheless, emerging market borrowers are far less fiscally profligate and indebted than the US Treasury, so any resulting volatility will be much less savage than that which occurred in emerging bond markets when the US Fed hiked in 1994. The other big event in the emerging market bond universe is the upcoming restructuring in Argentina. Argentina went into default on some US$90 billion of sovereign bonds in 2001, the biggest ever sovereign bond default. Holders will have to accept a write-down on face value, but investors that bought the defaulted bonds at or around 25% of face value in late 2003 are likely to see appreciable capital gains.


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