An 8% coupon might whet the appetites of some investors at a time of low interest rates, but many would expect greater compensation for investing in a country that has defaulted on its debts six times in the past 100 years. Indeed, investors are not earning much more than they would from buying debt issued by emerging countries that have not been sued by hedge funds.
Bonds issued in local currency currently yield an average of 6%, which is attractive while inflation in the emerging markets averages 3.7%. The offer is even more desirable when compared to the negative return five-year paper issued by Angela Merkel generates (-33%).
Elsewhere, dollar-denominated debt pays 5.2% over seven years, which is around 300bps higher than the compensation offered for holding US treasuries, while emerging market corporate debt yields around 5%.
Ashmore believes that some local currency bonds could make investors a 50% return in US dollars over the next five years. It expects external debt to make somewhere in the low 30s, while corporate bond investors will earn at least 25% over the same period.
“I’m bullish on the EM fixed income asset class,” Dehn says. “It will dramatically outperform developed markets in the next five years.” So the average returns are attractive, but Argentina’s long running saga to settle its default highlights the risks that investors take for owning paper issued by developing nations. Pension funds need to decide if the returns are worth the risks they are running.
The good news is that these yields are backed by solid fundamentals. It is not just depressed returns in the developed world that are drawing institutional cash back to emerging market debt.
Emerging world currencies hitting a 13-year low at the start of 2016 is fueling demand for exports which, along with fiscal reform, is pushing economic growth projections higher, especially in some of the regions’ largest economies – Brazil and Russia.
THIS TIME IT’S DIFFERENT
Local debt in the developing world endured a horrific few years where investors faced double-digit negative returns for taking double-digit volatility risk. The catalyst behind the sell-off that started around four years ago was that central banks in England, the US, Japan and the European Union started buying $15trn worth of government bonds.
“The single largest intervention ever made in global bond markets,” is how Dehn sums it up. “It is the equivalent of 15% of all outstanding bonds in the entire world.” This saw investors dump the emerging markets and plough the proceeds into US dollars, German debt and US equities. Five years later the flow of liquidity into these assets has made them expensive, leaving little room for capital gains.
“Now that the source of those capital gains is fading, money is moving the other way,” Dehn says. “It is going to be the sheer brutality of the relative returns that are available in EM compared to developed markets which is going to lead the money back. That is the underlying driver of all of this.”
Lazard Asset Management’s view is that the bottom of the emerging market debt sell-off was reached in February 2016. “So we are about 18 months into what has been a pretty solid bull market recovery,” says Arif Joshi, a portfolio manager in Lazard’s emerging markets debt team.
This recovery has shown its resilience by shrugging off various negative political events. The vote for Brexit and the election of US president Donald Trump, who campaigned on an anti-emerging market ticket, didn’t halt demand for sovereign debt.
Investor confidence was boosted in July when plans for a border-adjusted tax, which would have put a 20% levy on goods entering the US, were dropped. This removed another potential risk for the developing world with such a tax potentially strengthening the dollar and therefore reducing the return on local currency debt.
The recovery has also survived falls in oil prices this year, which Joshi points out is an indication at how strong the underlying fundamentals of this rally are. So if commodity prices stabilise and there is more co-ordinated global growth, investors could receive “pretty significant returns even from today’s starting point going forward”, he says.
Slowing growth and a rising debt ratio has made China a global concern, but credit default swap spreads have narrowed in the past 18 months to pre-2014 levels. The IMF has warned that its debt is at dangerous levels, but also noted that growth was being driven by policy, supply-side reform and a boost in exports.
There is also greater diversity in that the number of issuers in these markets is growing. There are 66 governments that have tapped international investors for cash, up from 32 in the past decade and it looks like there are more to come with Tajikistan announcing plans to launch its maiden bond. A greater number of issuers bring greater diversity to fixed income funds, resulting in lower volatility.
The fundamentals driving the market’s resilience makes Dehn believe that yields are higher than they should be in this asset class and that future issuers in these markets could raise cash cheaper.
“There is an arbitrage here,” Dehn claims. “Yields should be lower than where they are now and that capital gain will be realised over the next five years or so.
“That is why I’m expecting more than the 26% return you will get if yields stay constant,” he adds. “I think you are going to get a little more than that because the asset class is mispriced.”