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From Adviser Guide: Emerging market debt funds

Q: What are the pros and cons of emerging market debt?

A true stress test, solidifying the success of emerging market growth and reform momentum, was the financial crisis of the last decade.

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

Rob Drijkoningen, head of global emerging markets for ING Investment Management, said emerging markets became a driver of global growth, posting average GDP growth of 2.4 per cent in 2009, while developed economies (G7) experienced a contraction that averaged 3.4 per cent.

During the same period, Mr Drijkoningen said emerging economies continued to run current account surpluses, maintained sustainable debt levels and were able to undertake countercyclical fiscal and monetary policies to support growth.

The evolution of fiscal balances between emerging and G7 economies brings the points across, according to Mr Drijkoningen.

Post the Asian and the Russian crisis in the 1990s, he said emerging fiscal balances ran higher than G7 ones, but since 2002 they have moved structurally lower in absolute and relative terms.

In 2009, Mr Drijkoningen said emerging countries ran at half G7 levels and the gap between the two is expected to persist over the next three to five years given the dramatic fiscal adjustment required in the developed world.

From 2002 onwards, he said outstanding emerging market debt stock has grown exponentially.

On the supply side, Mr Drijkoningen said this phenomenon was supported by significant improvements in emerging countries’ fundamentals and contributions to global output and growth, causing the outstanding debt to rise in absolute terms.

On the demand side, he said the general search for yield resulted in strategic allocations from foreign investors.

Also, he said domestic institutional investors increased their demand for a broader range of investment opportunities in their domestic currencies.

On average, Mr Drijkoningen said total emerging market debt stock has grown by about 16 per cent a year since 2002.

Growth rates of external debt were constant around 11 per cent, he added, while domestic debt has grown at a faster pace of 17.4 per cent since 2002.

Brett Diment, head of emerging markets on the fixed income team at Aberdeen Asset Management, said the pros of emerging market debt are:

1) Global growth indicators better than expected, supportive for EMD.

2) Emerging markets offers dynamic opportunities with growth rates of more than 4 per cent. The IMF has predicted that by 2013 emerging economies will account for more than half of the world GDP.

3) Hard currency spreads are falling but remain attractive given lower default risk.

4) Emerging market sovereign debt has shown a steady improvement in credit quality with a growing proportion of bonds in the investment grade range.

5) Emerging market currency and corporates are poised to outperform as risk appetite improves.

6) Local currency debt is attractive as there is potential return from higher yields than in the case of dollar-denominated debt. Currency appreciation is also highly favourable.

7) Inflows into emerging market debt are resuming as investors seek yield in a lower for longer environment.

8) Developed world interest rates are set to remain low for the foreseeable future. Emerging markets seem to have removed themselves from the current crisis somewhat and can offer investors a more compelling yield.

9) Market fundamentals and valuations have been attractive. Default rates have been low.

10) Over the last seven years corporate bond issuance has been $937bn, more than double the level of sovereign bond issuance. The emerging market corporate bond market has become appropriate for a wider range of investors due to its size, liquidity and improving transparency.

Cons are:

1) Prominent risks include eurozone sovereign debt crisis, a potential Chinese ‘hard landing’, rising oil prices and an increase in US interest rates.

2) Ongoing risks include credit risk. Sovereign default is expected to remain low in the coming years, reflecting the improved fiscal and debt trends in the developing world. Such trends are supported by robust external reserves, positive terms of trade and, generally speaking, reduced political risk.

Local currency debt is rated higher than hard currency debt, which reflects historically lower default rates, and a government’s higher fiscal and monetary flexibility.

3) Currency risk, that is the risk that the currency in which the debt is issued is overvalued relative to investor’s currency and therefore the value of the investment will decrease as a result of currency depreciation.

4) Interest rate risk: the risk of interest rates increase due to fundamental or technical factors, such as a policy mistake.

For emerging market corporate debt the risks are:

1) Transparency and corporate governance, like any emerging market investor, yet corporate bonds suffer from market liquidity and bond structure.

2) In terms of capital structure, priority access to cash flow is crucial in determining default and recovery scenarios, which in turn drives down the relative valuation of a bond. The exact position of the debt within the company structure can be more complicated to discern than in developed markets.

3) Accounting standards and corporate governance in emerging markets still somewhat lag those of developed economies.

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