After a barren year-and-a-half, emerging market debt (EMD) has seen a resurgence of interest in the last few months as foreign investors turn to the asset for that most precious of things right now—yield. Allocation to EMD slumped to $35.2bn in 2015—compared to an average of around $250bn in the three previous years—as concerns over a slowing economic environment, in particular in China, checked investment from foreign asset owners. But after a slow start, things have gradually picked up since the middle of this year. The third quarter of 2016 saw the highest foreign influx of money since 2014 with $27bn of non-resident flows into the market, according to statistics by the Institute of International Finance (IIF). And it seems likely that this will continue to increase, according to industry participants.
“We have come through a period of negativity,” says Colm D’Rosario, senior portfolio manager, emerging markets, at Pioneer Investments. “Many countries in the emerging markets have adjusted their balance sheets to deal with the prospects of slower growth. You have seen asset disposals and political regimes changing as well as currency adjustments. With yields in developed assets down and equities under pressure, investors have returned to look for carry and yield in the emerging markets.”
The yield draw for investors in EMD is hard to ignore right now. The JP Morgan EMBI index of sovereign EMD was up 14.3% to October. Hard currency EMD currently yields around 350bps over treasuries. Yields of local currency debt, meanwhile, are now at around 6.2%. While the money coming into EMD has seen sovereign spreads over US treasuries compress by more than 80 basis points in the year, with yields on hard currency debt coming down from 7% at the beginning of 2016, participants believe there is still much more value to be found across the market.
“For any matrix you look at the allocation to EMD is much lower than it was a couple of years ago,” says JC Sambor, deputy head of emerging market fixed income at BNP Paribas Investment Partners. “There is still a lot of room before it becomes bubble territory. The flows are very much diverse and sustainable.”
Diverse investors
Increased confidence has seen an increase in the diversity of investors putting their money into the asset with new investor classes coming into the market. One of the key movers in 2016 have been insurance companies driven by the new Solvency II risk-based rules which allow them to better tailor the amount of regulatory capital they hold against EMD.
“There are fewer investors in EM debt than pre-taper tantrum days,” says Zsolt Papp, head of emerging market debt client portfolio management at JP Morgan Asset Management. “But what we are seeing now is a broader range of investors. Because of the low interest rates people are looking at markets that three to five years ago they wouldn’t have touched. For insurance companies, the new Solvency II rules encourage a risk-based approach which means a Mexican company rated ‘BBB’ is comparable to a US company with the same rating.”
The growth in confidence has also seen a move into riskier assets with investors shifting from sovereign debt to local currency and corporate debt and, in some cases, high yield. BNP’s Sambor says he is “much more excited” on local currency debt than sovereigns currently, with strong yields and the prospect of currency appreciation, likely to drive further foreign investment. Local currency debt has been underinvested compared to sovereign issues in recent years—foreign ownership of local currency debt is currently around 29% against the peak of 36% three years ago. But putting money into local currency debt is not easy. Local currency investors are exposed to both interest rate and currency risk. The latter is both expensive to hedge and volatile.
“Local currency is for the brave—you need to absorb currency volatility,” says Papp. “The dollar debt market is easy to access.”
Still, while EM currency hedging costs have risen over the past couple of years, relatively speaking this is not very different to the situation in other currencies right now.
“For a euro investor, for example, hedging a dollar position has risen a lot,” says D’Rosario. “This has taken the shine slightly off dollar assets. Although hedging EM currencies has also risen, if you take the cost of hedging the FX, the yield on local currencies as an asset class is superior to most of the dollar universe.”
Liquidity assumptions
Apart from the yield attraction, from an overall trading perspective there are a host of other positives about EMD right now—liquidity being one. Investors have, in the past, avoided EMD because of fears over their ability to trade out of emerging market assets. But the situation is improving. While liquidity in the developed fixed income markets has been squeezed by central bank asset purchase programmes and shrinking dealer inventories, relatively speaking, EMD liquidity has remained stable over the past few years.
“If a bond is included in any major indices you can assume it is liquid and will get support from trading desks and research,” says Papp. “It also helps if it has an issue size of $500m or more. You could say sovereign EMD liquidity is now comparable to a mid-sized European issuer like Belgium or the Netherlands.”
A hard currency sovereign issue is more than likely to be backed by trading desks at global banks and by local investors –particularly in countries like Malaysia, Turkey, South Africa, Mexico and Brazil—making many as liquid as a mid-sized European sovereign.
“Liquidity in fixed income is down as a whole,” says D’Rosario. “You have not seen an improvement in EM liquidity but at the same time there has been a deterioration in developed market liquidity with wider bid/offer spreads and reduced levels of trading. This may push more to look at EMD.”
Investors have also been able to take comfort from clearing and settlement terms of EMD. Most sovereign EMD can be settled via major clearing houses such as Euroclear, for example, and can be traded like any other bond issued in a major country.
Still, not everybody is convinced by the growth potential of EMD. The flipside to the recent revival of interest has led to some questioning the idea of a bubble developing in the emerging markets. In overall terms, the market has grown exponentially in the last ten years. The cumulative inflow into EM debt stood at $123bn in 2014 against just $3.9bn 2005, according to JP Morgan. And much of the money put into the asset this year has been driven by yield-seeking investors in what is being called the “there is no alternative” trade. Yield-hungry investors have already been diversifying into riskier destinations—the likes of El Salvador, Mongolia, and Zambia. The move to riskier assets brings with it a need for careful due diligence. Emerging markets are more prone to political risk and the trading risks associated with changing terms. Investors also have to be aware of taxation on EMD. For example, institutional investors looking at benchmarks may not always get a full picture because they do not include taxes.
What bubble?
“Some of the markets also have withholding taxes so you have to pay a tax on coupons,” says Sambor. “These are not incorporated into benchmarks. It could have a negative impact on trading and liquidity—but we do see that countries are looking to lower this.”
At the same time large parts of the local currency EMD market is still cut-off to foreign investors. Countries like India and China have long had a quota system in place to restrict foreign investment into the local asset markets.
But according to Ian Coulman, chief investment officer at reinsurer Pool Re, the threat of an emerging market bubble has at least diminished considerably by changed to the market structure, to what it was ten or twenty years ago.
“The bubble risk is more country-specific now,” says Coulman. “There is less contagion effect than there was twenty years ago. While it can be volatile and there are periods of stress and defaults if you have a good manager the yields on emerging market debt are attractive right now.”
Coulman says that the flow of money into EMD in the last ten years has prompted economic and regulatory reforms which have increased comfort levels for investors allocating into the asset. This is perhaps reflected in the relative stability on the corporate side. While year-to-date corporate defaults in high yield EMD reached 3.7%--the highest level since 2009—this remains well below the US high yield default measure of 6%. And investors are getting compensated for the risk—returns on high yield EM debt stood at 15.65% in October, according to data from JP Morgan.
Sambor says the concerns over high yield investors—what are known as “crossover or tourist” investors—in the summer proved unfounded. Most of the money coming in appears to be from longer-term asset owners, he says. While there remain macroeconomic risks on the horizon—specifically the possibility of a US interest rate hike and falling oil prices impacting oil producing countries. But, overall, the emerging markets are a lot less emerging than they were ten years ago. In a low rate environment in the developed world, the potential yields on offer will continue to attract investor interest.