Thursday, September 23, 2010

Debt Markets in Emerging Countries Develop Spectacularly



Earlier this month, Investments & Pensions Europe (IPE), one of the most important professional magazines for institutional investors published an article by Joseph Mariathasan. It was an excellent overview of trends in the market for EMD (Emerging Market Debt), which is developing at rocket pace. A few years ago this niche market within fixed income space consisted of loans issues by governments from Emerging Markets, mainly in hard currency. There was not much interest in local currencies because these bonds were considered too risky. Reason: income uncertainty, lacking monetary discipline and the perception that governments would be too sensitive to debt explosions whenever something went wrong economically. Result: they would print money and hyper inflation and deteriorating currencies would destroy any potential for reasonable returns. That is what we have seen in earlier crises in Emerging Markets in the 80s, 90s and before that we didn't even take portfolio investments in those markets seriously.

But the world has changed. At the moment debt levels in Developed nations are at about 100 percent of GDP, whereas debt levels in Emerging countries are at a mere 40 percent. GDP growth rates in Emerging countries are higher as well. So where is the risk?

From Niche to Mainstream

This has led to huge growth in both the hard currency EMD market - where we now see both sovereigns and large corporations from EM countries issue debt in USD (primarily), Euros and other strong currencies - as well as in local currencies (where the sovereigns still dominate).

The next step will be that the world will accept loans by corporates in Emerging Market currencies. It is a fact that the market is growing up. At the moment about 20 percent of global debt is from Emerging countries. Not as much as their share of global GDP, but that is to some extent normal because - as we indicated earlier - their debt levels are lower than those of Developed nations.

Growing numbers of Western institutional investors and even some funds aimed at private investors have discovered EMD as a new, interesting asset class. An alternative for high yield fixed income, issues by corporates in the Western world that have ended up in shady waters due to financial distress. 

The same ideas apply:

1) Top-down the investment manager tries to avoid excess risk by proper diversification. 

2) Bottom-up he or she tries to cherry-pick the best, i.e. most undervalued, loans.

3) As an add on we have of course - when dealing with local currency EMD - the cherry-picking of currencies. But since that doesn't seem the hardest part at the moment, with most EM currencies expected to appreciate vis-a-vis the Euro and Dollar, the asset class is developing.


Yields have come down to such an extent that some are even assuming that there is an excess momentum, with people actually paying too much. LMG believes that this is an exaggeration. We believe that the way yields have come down, and the increased issuance of EMD are indicative of the growing interest in these markets. And this is something that cannot be seen as anything but logical, based on the economic performance of these nations.

This week a Moroccan government delegation is traveling all through the Netherlands for one-on-one meetings with local institutional investors. For those of you not familiar with the Dutch market: Holland is relatively small but its institutional market is one of the largest worldwide with total assets far exceeding the size of GDP.  

Morocco, with a BBB rating is promising a lower yield than debt-struck Ireland - who still have a AA rating for their Euro-denominated debt - but it looks as if the Moroccan government will be able to borrow against a rate lower than what Ireland has to pay at the moment!

But the group of countries is diverse

But that is not to say that the overall group of countries in which you can invest when allocating money to Emerging Market Debt is not very diverse:

It ranges from low risk countries like Taiwan and Czech Republic all the way up to far more risky ones like Turkey, Philippines, Nigeria, Indonesia and South Africa and even more riskier Frontier markets like Ghana, Uganda and Sri Lanka.


But still: the big gain for all of us is that all these nations are now able to borrow against reasonable conditions from international financiers. And this can only be in the interest of them and their investors. However: all these countries know that the loans they get from Western investors are NOT to be seen as the basis for their next large structural investment program. Portfolio investments have a proven track record of being volatile. Of being related to trends in the global market. Whenever the market sentiment shifts, portfolio investments might easily leave the country again. Notwithstanding this fact, they are good tokens of international prestige for any country capable of issuing them. And this implies that the likelihood of attracting Foreign Direct Investments (i.e. Western firms buying domestic firms and/or setting up new entities) - far more sticky and long-term! - will increase as well. And that is great news.

Caveat: contagion is always a by-product of previously segregated countries who are now part of the global economic family. All those newly developing countries need to be aware of the fact that sometimes the international factors will dominate local ones, as a result of which management of international financial crises will become a new ball game that might require attracting better educated financial specialists either from abroad or internally after upgrading local education facilities.

But we are confident that the current trend is persistent, with debt markets undergoing the same rapid development that did already set in earlier in the equity market. We believe that serious investors should at least allocate 10 percent of their fixed income portfolio to EMD. There are good funds available to do so. 

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