Seeking Adventure In Exotic Markets
August 10, 2012
U.S. debt yields put you asleep. But you better be on your toes, with the adventure involved in emerging market bonds.
Consider the investing wanderlust of Acadian Asset Management. The firm invests in the debt of more than 30 developing economies, ranging from bonds issued by Zambia, Uganda, and Serbia to bonds issued by more mature governments, such as those of Uruguay, Brazil, Mexico, China and South Africa.
Acadian invests in bonds issued in the country's local currency, leaving the dollar-denominated debt to the lightweights. It's been earning returns of nearly 10%.
"Local currency debt is a growing universe," says Bryan Carter, head of Acadian's emerging market debt team. "There is a lot going on in this space."
Not all asset managers are as intrepid as Acadian. But sovereign debt, and in some cases corporate bonds from still-developing nations, is entering the mainstream, with major names such as Pimco embracing developing issuers to escape the U.S. market's depressed yield curve. This is rapidly changing industry notions on the credit worthiness and risk of this asset class.
"Agencies have more faith in these countries. Managers have more comfort. Many of these countries carry higher ratings than they used to," says Eric Jacobson, director of fixed-income fund research at Morningstar.
Jacobson says that the bonds of resource-rich countries have been in favor, such as those issued in South Africa, Russia and even Venezuela. Indonesia is another country that is gaining fans. Mexico has also been attractive, despite the drug headlines, because of healthy fundamentals.
Carter at Acadian says that this sector is big-and growing rapidly. For example, he says, locally-denominated issuers probably out-number hard currency issuers five-to-one. And sovereign bonds are not the only investment, any more.
"This is a really large universe," Carter says. "If somebody says that they are investing in emerging market bonds, they are not really telling you much. They could be buying emerging market index bonds, corporate bonds, dollar bonds, local currency bonds, inflation linked bonds, or cash instruments."
Morningstar's Jacobson says that the category has taken in more than $10.6 billion through June. With more than $60 billion in total net assets, he says, the category is three times the size it was in mid-2008.
Many approach emerging market debt the same way travelers choose destinations. Hard currency sovereign debt of BRIC countries like Brazil, Russia and China get all the new entrants-the tourists so to speak.
More experienced travelers look at local currency debt, which is debt issued in the local currency of the country in which it is issued.
This is a newly growing area for managers, according to Morningstar analyst David Falkof. Although this market has been around for a while, it hasn't had the liquidity that U.S. fund managers previously sought. However, they offer higher yields than hard-currency debt, issued in developed nations currencies like the dollar, often 100-200 basis points higher, according to Carter at Acadian.
The hardiest of explorers go for frontier debt, issued by countries that are new to global issuance, says Falkof. These include countries such as Iraq, Ghana, Ecuador and Pakistan.
Finally, Falkof says, corporate bonds in some of these young markets are becoming hot. Often, he says, an issuer would be a multinational company that would just have operations in a particular nation, thus getting the "emerging market " classification even though it really is financially stable.
"A lot of managers talk about the large amount of new issuance in emerging market corporates," he says.
The yields can be attractive, says Carter at Acadian. Brazilian yields have run 7% to 8%, depending on duration, while Uruguay has seen 10 to 12% yields and South Africa roughly 10%.
Meanwhile, Zambia has seen about 12% and its currency has been appreciating because of a mining boom and investment from countries like China.
Of course, there is the issue of creditworthiness. Ratings run the gamut. Carter says that Brazil has an A- rating, while South Africa has an A. Mongolia, which offers nearly 10% in yield, has a rating of BB. Egypt, which offers 21%, has a BB- rating.
When Carter's team looks at a country, it looks for institutional and structural improvements that will indicate a drop in interest rates, or increase in value of assets, over time.
One such important development is growing central bank independence.
For example, he says, some frontier countries you might not expect have strong governance regimes, targeting inflation and maintaining low prices.
Having the expertise in these countries is key. For example, Acadian has a dedicated frontier analyst as well as a head trader with 10 years of experience in these markets.
"They are hoping to find something that is a diamond in the rough," says Morningstar's Jacobson of managers in this space.
Jacobson says a common approach for investing in this debt is this: hold until the credit quality goes up and the yield goes down; then sell to garner the appreciation and rotate the money in another country that is looking cheaper.
A slow global economy can make emerging debt even more attractive, says Carter.
"If you are expecting a continued muddle-through scenario for the global economy, emerging market bonds are even better because they will benefit from lower inflation and Central Bank rate cuts," he says.
Also, Carter says that emerging markets often aren't correlated to the markets of other countries. "These bonds offer a very nice dividend in a muddle-through economy for a number of scenarios."