Benefits And Pensions Monitor Interview: Making The Case For Emerging Markets Debt
Emerging market debt (EMD) is attracting more interest these days, especially for pension fund sponsors looking for other sources of fixed income exposure. Nicolas Jaquier, emerging markets economist at Standard Life Investments, spoke with Benefits and Pensions Monitor about some of the elements of using this asset class.
Benefits and Pensions Monitor: To what would you attribute the increasing attraction of emerging markets debt?
A: It is the recognition of improvements that happened across emerging markets over the past 10 to 20 years. If you go back to the late ’90s when emerging markets really emerged as an asset class, they were in a very different position. You had the Asian financial crisis which was triggered by very high levels of public and external debt across the whole emerging market world. There were poor policy-making decisions, especially in the choice of exchange rate regimes. Many had fixed exchange rates. As an asset class, there were only 20 to 30 countries that we could truly invest in.
Today, there are many new entrants, many new smaller economies. That has been particularly the case over the last three or four years. Now you have 65 to 70 countries that have bonds that you can invest in so it is a much more diverse universe.
The metrics have improved a lot as well and the policy-making has improved drastically, both of which I think are linked. They have abandoned pegs. Most exchange rates are flexible.
Q: When we are talking emerging markets debt, are we only talking about government debt?
A: Debt issued by sovereign nations can be split in two. There are hard currency bonds, which are usually denominated in dollars, sometimes Euros, but not in their own currency. Then we have a separate strategy that invests in local currency, sovereign debt, but denominated in a country’s currency, for example, Mexican pesos.
However, the trend across emerging markets has been away from relying on external debt and more issuance on in their own currency, which means less vulnerability to the outside world and weaker currencies.
If you look at Ukraine today, it is a good example of how EMs were, in general, 15 to 20 years ago. There is a very high level of external debt in a foreign currency, dollars, and pegged exchange rates which tend to become over-valued over time. This means, at some point, the chances of a crisis will be high. It needs to make an adjustment so the exchange rate devalues, which means debt levels go up and it runs into troubles. Today, that is really more the exception than the rule.
I think there has been a recognition by investors and by credit rating agencies of these general improvements. So the index that we follow – the J.P. Morgan Emerging Market Bond Index – has 63 countries in it. If you go back to 2000, it used to be about 20 per cent investment grade and 80 per cent high yield. Now that is almost reversed. It is closer to 30 per cent sub-investment grade and 70 per cent investment grade. There is a recognition of all these improvements.
Q: What are some of the reasons for the improvements?
A: I think it is learning by doing and learning from mistakes. There was the crisis I mentioned, the Asian financial crisis. However, before that we had the tequila crisis in Mexico and the Latin American debt crisis. All were triggered by policy mistakes, over-indebtedness, and the poor policy preferences of ruling regimes that were running down the reserves. Eventually they realized that you have to get out of these boom and bust cycles and improve your policy setup.
Q: So in many ways it is dependent on the quality of the political leadership?
A: Yes, that is one aspect. Political leadership is important, but so too is the technical staff at the ministries of finance and the staff at the central banks where they are not politicians. Yet, I think there has been also great improvement in the capacity on that level as well.
Q: Have you seen much interest in this from Canadian institutional investors?
A: They are starting to look at it. It is still a relatively new asset class for them. They are starting to look at it especially if you compare emerging markets debt to the alternatives which are maybe U.S. and Canadian corporate and government bonds. You do get an attractive yield pickup over those for similarly, if not better, rated assets.
Q: What kind of yield?
A: The yield on the index in hard currency, in dollars, is about 5-1/2 and if you invest in local currencies it is a little bit higher. Currently it is just above six, 6-1/2. But then you do take on emerging market currency risk, which you do not have if you invest in hard currency bonds in U.S. dollars that can be hedged back to Canadian dollars.
Q: What is the impact of the growing strength of the U.S. dollar on these markets?
A: Some benefit, others not so much. The economies that are closely linked to the U.S. economy tend to benefit. So I am thinking of Mexico, also some economies in Asia that tend to manufacture a lot and eventually channel demand to the U.S. They do benefit from a stronger U.S. economy and stronger dollar.
In some places, the stronger dollar leads to a weaker currency, which can put some pressure on debt ratios if they have a large share in foreign currency, but that is really the exception. I mentioned the Ukraine, but I cannot really think of another one. Some of the corporates in some of these markets might be more sensitive but really that is by a case-by-case basis.
Q: The indications are that this year the U.S. could raise its interest rate. Will that have much of a positive or negative impact, or is it still dependent on how linked an economy is to the U.S.?
A: When the fed finally starts hiking rates, it will be because it is comfortable that the U.S. economy can withstand it and that means the U.S. economy is quite healthy. Generally, this is a good thing for emerging markets. I think once the fed starts hiking, it will be very gradual. It will spend a lot of time talking about it, announcing it.
However, while the global economy is very integrated, it would be a mistake to look at emerging markets as a whole in this situation. You really need to look at each country individually, which is how we approach this asset class. We use a very bottom-up approach where we analyze each country rather than treat it as a homogenous group. Many countries are not that susceptible to a hike in U.S. interest rates. The most susceptible are probably Turkey and South Africa which are still running large external deficits and rely heavily on portfolio investments. I was at the IMF World Bank meeting in Washington and I actually expected every policy-maker to talk about how they were going to respond to the Fed. What actually surprised me was it was barely mentioned so it does not seem like such a big issue for policy-makers. And I quite understand this because many of these economies have built buffers and are not that exposed to U.S. rates rising.
Q: Do investors get that point that you are really looking at individual country debt?
A: We are moving in that direction as we should. But it is true that traditionally it has been an asset class dominated by funds that follow the index quite closely. In the past, it used to be very much a decision to buy EM as a whole whereas now it is a bit of a move away from following the benchmark and trying to pick the good stories.
Q: What are the good stories today?
A: I like Mexico as I mentioned before. It has strong links to the U.S. and benefits from that with a decent performance from the U.S. economy, but also the reform momentum is quite strong, especially in the energy sector. I think it will be transformative for Mexico. That is one area that has been neglected. They have huge potential that has been underdeveloped for years.
We like India as well for similar reasons as it is one of the few places where there is strong reform momentum. In Hungary and Eastern Europe, valuations have really tightened a lot and it is now difficult to find value in the region. We usually underweight the region based on valuation. But Hungary is one that still has some value and trades above the rest. It had a bad global financial crisis seven years ago and since then, it has really restructured its economy. External balances went from deep deficit into surplus quite rapidly
There are a few frontier markets that we like selectively, such as the Dominican Republic, Ivory Coast, and Paraguay for instance. Like I said, the asset class has grown a lot and much of that growth has come from issuance by frontier markets for the first time. We do not think all of them are good investments, but there is some nice value to be found in these markets.
Q: Is the government debt usually a couple of steps ahead of corporate debt?
A: Yes, usually, especially for smaller countries, the sovereign will be the first one to issue debt. That is then used as a benchmark for the corporates to come to market as corporate debt will be priced off the sovereign bonds. From an investor perspective, what we have seen is institutional investors that have not looked at EM debt before, usually tend to look at EM sovereign debt first, invest there, and once they become more familiar and more comfortable with sovereign debt, they look at EM corporate debt.
Q: How much of the interest in emerging market debt right now is because of the state of interest rates and the state of pension plans looking to de-risk?
A: Yes, that is one factor, the hunt for yield, but I think it is going to be the case for many years still. Investors need returns. They need yield. If you cannot get it from advanced economies’ bonds, why not look at emerging markets debt?
Q: For first time investors looking at this asset class, are there things that they should be wary of?
A: You definitely have to do your analysis and that goes back to the point of buying the individual stories as opposed to the asset class. They should pay a lot more attention to each individual story, as not every single emerging market is a good investment. You have to know what is in the price. For example, I mentioned Turkey where we are underweight. It is not that we think Turkey is going to default. It is a well-established issuer, but you are not paid a lot of premium to compensate you for some of the risk. Whereas if you look at Mexico, it issued a 100-year bond, one of the longest dated bonds in emerging markets. That is one bond that we hold in our funds. It has a spread of around 300 basis points over U.S. Treasuries so it is actually more than what you would get by buying a long-dated Turkish bond. For us, that is compelling.
Q: What was your reaction when Mexico issued 100-year bonds? Did you jump right in?
A: We participated in that new issue back then. We knew Mexico as a decent issuer, that it had been doing the right things from a policy perspective, that that has been recognized by the credit rating agencies and by the IMF. The IMF has given it a credit line. That is something that it has advanced to only three countries. It is not an IMF program where it puts a condition on the country and then it disburses money. It is just a credit line that is there if Mexico ever needed it. It is a good sign of confidence, that the policies are the right ones. That was the right thing for it, to take advantage of low rates in the U.S. and locking in some financing for 100 years. As I was saying, there very good technical staff at its ministry of finance and a very good debt management office. The placement of that bond was testament to that.