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From Adviser Guide: Emerging market debt funds

Q: What are the different types of emerging market debt?

Emerging market debt can be distinguished into external and domestic debt.

By Emma Ann Hughes | Published Jul 12, 2012 | comments

External or hard currency debt is debt issued by an emerging market domiciled sovereign or corporate issuer, but denominated in US dollar, euro or yen.

Domestic or local currency debt is debt issued by an emerging market domiciled sovereign or corporate issuer and denominated in the domestic currency of the country of issue.

Rob Drijkoningen, head of global emerging markets for ING Investment Management, said he distinguished four segments within the broader emerging market debt asset class grouping on the basis of their exposures to different sets of risk premiums.

External or hard currency sovereign debt

This is the most mature segment, according to Mr Drijkoningen, and offers investors exposure to emerging markets credit risk and developed world interest rate risk.

Returns are a function of the level and changes of developed market ‘risk-free’ rates (for example, US Treasury yields) and changes in sovereign credit spreads (credit risk premiums).

External or hard currency corporate debt

This is the youngest segment and Mr Drijkoningen said this offers investors exposure to emerging markets credit and corporate risk and developed world interest rate risk.

Returns are a function of the level and changes of developed market ‘risk-free’ rates and changes in sovereign and corporate credit spreads.

Domestic or local currency debt (government and corporate)

This is the largest segment, according to Mr Drijkoningen.

Domestic government debt primarily offers investors exposure to emerging market domestic interest rate risk, and a currency risk premium that can translate into real currency appreciation, he added.

In essence, Mr Drijkoningen said domestic debt was a combination of local bond and local currency exposures.

For corporate instruments, he said the investor also has exposure to changes in corporate credit spreads.

Returns are a direct function of the level and changes of domestic markets ‘risk-free’ rates, he added.

Local debt curves can differ significantly in shape and levels from external debt curves.

Mr Drijkoningen said domestic factors such as inflation (expectations), economic growth (expectations), supply and demand in local credit markets, domestic savings and investments, and the role of large domestic investors, such as pension funds, were far more relevant in determining levels and shapes of local curves than external factors.

In general, Mr Drijkoningen said differences between domestic and external credit risk premiums are determined mostly by market characteristics like ease of access to local markets for international investors, capital restrictions for domestic investors wishing to invest abroad, presence/absence of withholding taxes or other legal/regulatory impediments.

He said: “This is a structurally different exposure from a purely credit risk related one.”

Emerging foreign exchange or local currency money market

This is the most liquid segment, according to Mr Drijkoningen, and offers investors exposure to currency risk premiums - which can, but not necessarily are, being captured by interest rate differentials - and real currency appreciation/depreciation.

Returns are a function of a number of macroeconomic, technical and market drivers determining the pace of real currency appreciation/depreciation.

He said these can be interest rate, inflation, and productivity differentials, balance of payments dynamics and volatility premiums.

Emerging market currencies are subject to a structural trend of appreciation versus hard currencies (US dollar, euro), Mr Drijkoningen added.

Main causes, according to Mr Drijkoningen, are the stronger external sectors of emerging markets and the higher productivity growth compared with developed markets.

Mr Drijkoningen said literature suggests that emerging market currencies can, on average, appreciate between 2 and 3 per cent a year over the medium to long-term.

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