Emerging market debt moving into the mainstream
Investor demand to drive capital appreciation
Emerging nations have been increasing their contributions to world growth. It is estimated that the sector will account for more than half of world gross domestic product (GDP) by the end of this year. World GDP growth is forecast to be 2.9% by the end of 2013, up from 2.6% in 2012; of this, developed countries are projected to grow at 1.4% (up modestly from 1.3% in 2012), whereas emerging countries are forecast to grow at 5.5% (up from 4.8% in 2012).
Most knowledgeable investors are well aware that emerging countries are currently in better economic shape than their developed counterparts. Emerging countries as a whole have continued to demonstrate improving economic fundamentals and structural reforms. In recent years, these developments have resulted in significant capital flows to the sector, particularly to emerging market debt, which provides investors with a direct method to take exposure to this improving fundamental theme and capture the strong risk-adjusted returns that this asset class provides.
A multi-decade secular trend
Amid an uncertain global risk environment, growth continues to be lacklustre in developed countries. However, growth has recovered in emerging countries according to Pictet Asset Management’s leading indicators (see below). The indicators show a clear divergence between the growth trajectories of emerging and developed countries.
The growth of emerging countries has not come “at any cost” – even though the emerging market sovereign debt asset class has grown significantly over the past ten years from US$400 million to US$2 trillion as at end of December 2012. Emerging countries have on average a debt-to-GDP level of only 32%, as opposed to 106% for developed countries on average. Consequently, emerging countries are better equipped to repay their debts.
Coupled with structural reforms, such as central bank independence, the fundamental improvements are increasingly being reflected in the improved ratings of emerging countries. Since the onset of the global financial crisis, emerging sovereigns have amassed an astonishing 189 upgrades versus 129 downgrades for developed sovereigns.
In spite of these developments, emerging market debt is sometimes still viewed as a niche asset class. While offering attractive returns (annualised returns of 11% for emerging USD debt and 14% for emerging local currency debt since end 2001), emerging market debt importantly also offers strong risk-adjusted returns. In particular, the resilience of the asset class in 2008 was a surprise to many investors, with emerging market local currency sovereign debt losing only 5% in that year.
A key reason for this resilience is the return drivers, which help stabilise the performance of the asset class. In the case of emerging markets’ local currency sovereign debt, the main drivers of return are local bonds and currencies. In 2008, emerging currencies came under broad selling pressure amid a weak global environment and lost 14%. However, as global growth fell and inflation in emerging countries dropped, emerging central banks moved aggressively to slash interest rates (e.g. from end 2007 to end 2009, Brazil’s central bank cut rates by 250bp) and these interest rate cuts buoyed the total return by 11%, resulting in a total return of -5% for the asset class as a whole.
Global demand on the rise
“Overall, emerging market debt was driven by a recognition of emerging markets’ favourable debt fundamentals compared with developed debt markets, such as debt to GDP ratios one-third the developed market average and stronger growth prospects,” says Simon Lue-Fong, head of emerging debt at Pictet Asset Management. “In addition, the ‘low rates for longer’ environment with significant quantitative easing coupled with underweight long-term investors created a pull factor for the asset class.”
The flow story continues to be very strong and in particular, institutional allocations to emerging market debt as a whole looks set to continue. One of the largest sources of demand is global institutional investors, such as central banks, sovereign entities and pension funds. There are still developed pension funds with no exposure at all to emerging market debt, but this is slowly changing as consultants and their own optimisation studies tell them otherwise. Especially given the scarcity of safe assets, yields and growth; they need emerging market debt exposure for coupons, returns and diversification.
Also, the attractive yield differential, that emerging market USD debt provides investors with a yield of 4.6% compared to only 2% for US 10-year Treasuries, has not gone unnoticed by insurance companies and wholesale and retail investors.
Aside from global investors, one of the biggest sources of demand for emerging market debt assets are from emerging countries themselves – driven by an evolving demographic, emerging pension funds are some of the largest investors in their own countries’ government bond markets. Importantly, they are long-term holders and are integral to improving the breadth, depth and liquidity of emerging debt markets.
While Pictet Asset Management is positive on all three segments within the asset class – emerging market USD debt, emerging market USD corporate debt and emerging market local currency debt – Mr. Lue-Fong in particular points out the potential for emerging market local currency debt to provide attractive returns over the coming months. The asset class continues to offer an attractive yield of 5.5%, and in addition “there is improved potential for currency appreciation as we expect minimal policy easing in 2013 and improved emerging market growth. Capital appreciation will be driven by investor demand, particularly from underweight long-term institutional investors and a long-term structural shift to diversify away from G3 currencies, as shown by several of the world’s largest holders of foreign reserves.”
On the corporate side, emerging market companies have become more attractive to investors because they are evolving into global, shareholder-friendly businesses. A growing number of firms are rewarding investors with attractive dividends, and are developing better, higher-margin products and services as well as building stronger domestic and internationally-recognised brands.
“The emerging market corporate debt sector has grown rapidly, from US$46 billion in 1998 to US$803 billion in 2012, and looks certain to become even larger, driven by increasing demand and a rise in new issuers. The investment universe includes the full range of sectors, from financials and utilities, to transport and industrial,” points out Alain Nsiona Defise, head of emerging corporate at Pictet Asset Management. “It has expanded significantly since 2001, from 13 countries to 41 and from 14 industrial groups to 42 in 2012”
“As banks continue to limit lending, companies in emerging countries are turning to the debt markets to raise capital. At the same time, local pension funds, retail investors and private banks are investing in increasing numbers, seeking new ways to generate yield.”
The precarious state of some developed countries’ finances sits in contrast with the steady progress in the credit quality of many emerging countries, which have implemented sound fiscal and monetary policies. This has provided a stable macro-economic environment to foster the rapid growth of domestic companies.
“In fact, aggregate default rates of emerging market companies have been steadily improving, reflecting the higher credit standings of their sovereigns. Nearly 70% of the emerging market corporate debt in this sector are now rated investment grade. Overall, corporate debt issuers in emerging markets tend to be less leveraged than a US company with the same debt rating. Improving transparency has also helped make this asset class more investor-friendly,” says Mr. Defise.
Emerging market corporate debt realised record issuance in 2012, with approximately US$300 billion in primary issuance taking the overall asset class to almost US$1 trillion, which is now close to the size of the US high yield market.
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