Returns and diversification thanks to emerging-market debt
| 06 August 2009 |
| Press Article Emerging countries are now much better equipped, structurally, than in the 1990s to cope with economic downswings. Moreover, they can draw on support from the major supranational agencies. Dollar-denominated emerging-market debt is an excellent diversification vehicle for private and institutional investors, featuring as one of those asset classes with highly promising potential for delivering returns over a 12/18-month investment time-frame. |
 By Alexandre RisSenior Product Manager Pictet Funds Geneva |
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Unlike what happened a decade or so ago, emerging countries are currently experiencing much the same sort of trend as economies in the industrialised world. They have been shaken by the same economic crisis, with their rates of growth in gross domestic product (GDP) sinking, primarily as a result of the slowdown in their exports heading towards developed countries. On the positive side, the economic impact would appear to have been less harsh this time round courtesy of the string of structural reforms implemented by these countries over the last few years, reforms that are beginning to deliver benefits. Governments in emerging countries have striven hard to give their central banks greater independence, keep inflation on a tighter leash, work towards balancing their public budgets and build up foreign-exchange reserves. What is more, a good many countries, such as Brazil or even China, the latter having announced a reflationary package worth almost USD600bn, have pushed through significant measures aimed at stimulating domestic demand and, hence, lessen their reliance on exports. Low default risk Economies in the emerging world now look much better equipped to cope with the crisis and can, moreover, rely on support drawn from the world's major supranational agencies. Here's just one example: the International Monetary Fund (IMF) has USD750bn of funds available to bail out those countries most in distress whereas, according to JP Morgan's indices, the actual market value of emerging countries' external debt totals less than USD300bn. The US Federal Reserve Board has already made swap lines available to countries like Hungary, Brazil, Mexico or South Korea to keep them adequately supplied with liquidity in dollars. It should also be borne in mind that, although emerging nations' governments tended, in the past, not to be unduly bothered about frittering away their currency reserves to shore up flagging local currencies, this is, generally speaking, no longer the case as they know that carefully steering currency devaluation can help towards potentially sharpening the competitive edge of a country's exporting industries. |
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 Even though emerging-market debt in general does offer investors the prospect of attractive returns, the odd disappointment or setback cannot, of course, be ruled out altogether, rather like what happened late last year when Ecuador defaulted on its interest payments. Disaster scenarios on a much broader scale, such as occurred when Argentina's debt was restructured in 2001, do not look all that likely though. Nonetheless, it is still advisable today to go for a diversified approach to spread 'sovereign' or 'country' risk. Taking this approach can be appealing for both retail and institutional investors keen to invest on an international scale as emerging-market debt denominated in US dollars tends not to be closely correlated with other asset classes, with this decorrelation having increased further since early 2009. This debt segment today thus constitutes for investors an investment play in its own right, offering some particularly enticing opportunities to inject diversification into portfolios. Asymmetric risk/reward trade-off in investors' favour As with all categories of risk asset, dollar-denominated emerging debt was buffeted by storms during the final quarter of 2008. Yield spreads jumped, up to levels of some 900 basis points on average, reflecting the extra risk premium being demanded for this type of investment vehicle. Spreads have since stabilised at around the 500bp-mark, which still suggests that expectations of a high default risk are still being priced in (see the chart). These fears are unlikely to materialise in the near future, at least not for the big emerging countries as they have been accumulating sizeable currency reserves and would be able to seek assistance from supranational agencies. Moreover, the steady upgrading of most emerging nations' sovereign credit ratings by the agencies would appear to lend weight to this argument. |
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Over the coming 12 to 18 months, these fat spreads mean that the risk/reward trade-off is angled to investors' advantage. On the one hand, high coupon yields offer the prospect of handsome cash flows whilst, on the other, the deep discounts to par on some securities offer the potential for some sizeable capital gains to be made. So, even if the recovery in the global economy might yet have a few unpleasant surprises in store – with a 'W'-shaped upswing and an inflationary exit from the crisis in late 2010/early 2011 – the upturn is definitely discernible, which is not what the current pricing of emerging debt would have us believe. Lastly, several emerging countries' decision to embark on a process of buying back their dollar-denominated foreign debt, financed by issuing debt in the local currency, provides investors with two more good reasons to invest. Firstly, the default risk on reimbursement of dollar-denominated government bonds is much lower. Secondly, the buy-backs will also fuel brisk demand for the asset class. All in all, given the track record for dollar-denominated emerging-market debt, with its annualised return of +8.62% p.a. since the end of 2001, re-initiating exposure to this asset class can be soundly recommended for its combination of diversification and attractive expected returns. |
