Dollar or local? Unravelling the complexities of emerging market debt Pictet Asset Management October 2012
For professional investors only
Summary
Emerging market debt is a dynamic asset class which is fast evolving from a niche to a mainstream investment for a broad range of investors. This commentary compares and contrasts the two main sub-sectors of the market, dollar-denominated and local currency denominated debt; the aim is to give investors a better understanding of the benefits and risks each can bring to a diversified portfolio. An overview is given below.
FIGURE 1 – SOVEREIGN DOLLAR VS LOCAL CURRENCY EM DEBT 1
1
US dollar EM bond market represented by JP Morgan EMBI Global index, local currency bond market represented by JP Morgan GBI-EM (Broad) index. Figures to September, 2012. Returns and volatility shown on an annualised basis covering 10 year period to end September 2012.
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US dollar bonds
Local currency bonds
Number of countries
48
16
Average credit rating
BBB+
A-
Credit rating range (individual countries)
Broad
Narrow
Range of securities types available
Narrow
Broad
Liquidity
Good in some, poor in others
Good in many markets
Sources of return
Treasury return Credit return
Bond return (rates) Currency return
Annualised return/Volatility (10y)
11%, 9%
13%, 12%
Dollar or local? Unravelling the complexities of emerging market debt
Scarcity. This is the legacy of the credit crisis. The US housing crash and the ensuing deterioration of advanced nations’ public finances have cast investors into a world where growth is scarce, safe assets are scarce and attractive income-generating securities are scarce. Adapting to this new environment has not been easy. But investors are nothing if not resourceful. By discarding preconceived notions about risk and venturing into unfamiliar territory, the investment community has been able to find alternative providers of growth, safety and income. The asset class that is perhaps benefitting most from this change in the investment climate is emerging market (EM) debt, an area of fixed income that is evolving from a tactical into strategic holding for a growing number of market participants. EM bonds’ rising prominence in investor portfolios is justified: the developing world’s growth prospects, debt burdens, savings rates and demographics are the envy of many advanced economies, and promise to remain so for years to come. Yet for all its intuitive appeal, EM debt is a complex asset class. Its sub-sectors – local currency and US dollar-denominated bonds – possess distinctive attributes which in turn bring different investment benefits and risks to a diversified portfolio. It is our belief that investors with a sound understanding of how these broad sets of EM debt investments differ can make betterinformed decisions when it comes to structuring their EM debt allocation. To that end, analysing the composition, sources of return, risk-return profile and correlation characteristics of each sub-sector should provide some useful insights.
Emerging market debt – dollar or local? | October 2012
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Differences in the composition between dollar and local EM bond markets
In comparing US dollar and local currency debt markets, investors will notice substantial differences in both the number and the credit profile of sovereign borrowers in each sector; the variety and type of debt securities available in each segment also differ markedly. Composition 1: US dollar – a larger number of sovereign credits of varying credit quality Sovereign US dollar bonds provide access to the broadest range of investible emerging markets – the JP Morgan EMBI Global index comprises 48 countries as diverse as Poland, which is also in developed market fixed income indices, and Guatemala, a frontier market whose bonds are not particularly liquid. Sovereign issuers of US dollardenominated debt fall into one of three broad categories: Advanced emerging markets – established, investment-grade sovereign credits such as Brazil and Mexico – large economies with highly-developed financial markets and a growing domestic institutional investor base. Over the years, these countries have been able to reduce their reliance on external funding in favour of local currency debt. Externally-financed, exportdependent nations – countries such as Argentina and Kazakhstan that possess generally liquid external bond markets and extended yield curves,
but whose economies and market infrastructure are at an earlier stage in their development. Such countries tend to be heavily reliant on exports of raw materials and, for a variety of reasons, have limited access to domestic funding. Frontier markets – these are riskier sovereign borrowers that are recent entrants to the international bond markets such as Pakistan, Ghana and Iraq. These countries are typically rich in one or more natural resources but are vulnerable to political turmoil and possess poor governance standards; their bonds are among the least liquid in the international markets. The diversity of the US dollar sovereign bond market is also reflected in its credit profile. Even though the aggregate credit rating of the JP Morgan Global EMBI index is BBB-, almost 40 per cent of the market is below investment-grade (Figure 2). It is because the EM dollar bond market is so varied in terms of its country and rating composition that it can benefit disproportionately during periods characterised by a sharp improvement in global risk appetite. In 2009, for example, when equity and credit markets staged an exceptionally strong rally following the collapse of Lehman Brothers, sovereign US dollar bonds outperformed their local currency counterparts by a significant margin. Argentina’s dollar bonds more than doubled in value over the year.
FIGURE 2 – AROUND 40% OF SOVEREIGN DOLLAR MARKET SUB INVESTMENT-GRADE Rating breakdown, JPMorgan EMBI Global Index B
17%
BB
19%
Investment grade
63%
Not rated
1% 0
10
20
30
40
50
60
70
80
90
100%
Source:JP Morgan
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Composition 2: Sovereign local currency debt is of higher credit quality Compared to the US dollar market, local currency sovereign bond investors have access to a select number of sovereign credits – there are only 16 countries in JP Morgan’s GBIEM (Broad) index of local currency debt. But although local sovereign debt markets are less diverse than their US dollar counterparts, their credit profile is superior – the aggregate credit rating given to emerging market local currency bonds by Standard and Poor’s is A-.
This testifies to the fact that large local bond markets are the preserve of the developing world’s most advanced economies – those that in the vast majority of cases have independent central banks, have developed a sophisticated market infrastructure and benefit from a large and growing domestic institutional investor base. As Figures 3 and 4 show, the countries that have managed to both tame inflation and develop a sound legal framework are less dependent on external financing.
FIGURE 3 – LOCAL BOND MARKET DEVELOPMENT AND INFLATION VOLATILITY Size of local bond market, % of GDP 80 —
MYS
60 —
THA HUN
40 —
ZAF
IND CHN 20 —
MEXCZE
TUR
CHL
PHL
POL
SVK BRA
HRV PER 0—
IDN
COL
RUS
0
5
10 15 20 Inflation volatility (volatility of quarterly year-on-year inflation over 10-year period)
Source: Burger, J., F. Wamock, and V. Wamock, ‘Emerging Local Currency Bond Markets’, Financial Analysts Journal (July/August 2012)
FIGURE 4 – LOCAL BOND MARKET DEVELOPMENT AND LEGAL RIGHTS Size of local bond market, % of GDP 80 —
MYS
60 — THA 40 — HUN PHL 20 —
2
CHN
BRA
ZAF
IND CZE
MEX IDN
0 — VEN
CHL ARG
HRV
POL
SVK
PER
COL
RUS 4
6
8 10 Legal rights (World Bank ‘Doing Business’ Indicators)
Source: Burger, J., F. Wamock, and V. Wamock, ‘Emerging Local Currency Bond Markets’, Financial Analysts Journal (July/August 2012)
Emerging market debt – dollar or local? | October 2012
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Composition 3: Local markets offer a richer variety of debt instruments While US dollar-denominated markets offer investment opportunities across a broader range of issuers, there is a richer variety of debt instruments in local currency markets, giving investors the ability to better hedge interest rate, currency and inflation risk. Money market instruments are available across all domestic currency bond markets while inflation-linked debt, inflation-linked swaps and interest rate derivatives are also growing.
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Aside from corporate bonds, inflationlinked securities are among the fastest-growing areas of local debt: the volume of bonds outstanding has increased from less than USD 30 billion to around USD 300 billion over the last decade. Other hedging tools such as cross currency basis swaps and currency-linked structured products are also available in certain markets, although liquidity in such instruments can be limited.
Liquidity
Liquidity – the ability to buy and sell assets without causing unfavourable shifts in their price – is an area where investors in local bond markets enjoy a growing advantage over participants in US dollar bonds. With a market capitalisation of well over USD 1 trillion, the local sovereign
market, as measured by the JP Morgan GBI EM Broad Index, is almost double the size of the US dollar sovereign and corporate market indices combined. According to data from the Emerging Markets Traders Association, local debt now accounts for more than 70 per cent of the USD 1.53 trillion traded every quarter in emerging markets bonds.2
FIGURE 5 – SIZE OF EM LOCAL SOVEREIGN BOND MARKETS VS US DOLLAR EM BONDS % of the total EM market size 100 GBI EM (Local Sov) 90
EMBI Global (External Sov)
80 70 60 50 40 30 20 10 0 2002
2003
2004
2005
2006
2007
2009
2010
2011
(July) 2012 Source: JP Morgan
2
Source: Emerging Market Traders Association, June 2012
Emerging market debt – dollar or local? | October 2012
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Differences in sources of return
Beta: US dollar EM sovereign bonds US dollar-denominated sovereign debt instruments are credit – or spread – products that offer investors a yield pick-up over US Treasuries as compensation for the additional risks inherent to such securities. This yield spread not only acts as insurance cover against the higher probability of a default loss among EM borrowers,3 it also compensates bondholders for the fact that the asset class is less liquid than large developed government bond markets. Capital gains from spread products are primarily determined by two factors: the trajectory of benchmark US Treasury yields, over which the issuing entity has no control, and the course taken by the yield spread, which by contrast can be heavily influenced by changes in a bond issuer’s credit profile. These two factors do not carry equal sway in any one phase of an economic or market cycle – their influence changes over time, as Figure 6 shows. For instance, a downward move in US
Treasury yields – set in motion by the Federal Reserve’s quantitative easing policy – has proved a strong source of return across the entire dollardenominated EM credit spectrum since 2008. This has been an especially powerful force for sovereign dollar bonds, whose sensitivity to Treasury yields is greater than that of other areas of EM debt as they are of a longer duration. Looking ahead, however, it is reasonable to assume that a narrowing of yield spreads will become a more prominent component of investment return for EM dollar bonds. This is because the credit profile of borrowers in the developing world can be expected to improve further relative to the developed world as EM governments and corporations benefit from stronger domestic economic growth and lower debt burdens. Supply and demand imbalances also point to a narrowing in bond spreads – the volume of EM debt securities held by global investors is low relative to the contribution developing economies make to world GDP.
FIGURE 6 – WHERE RETURN COMES FROM: DECOMPOSITION OF EM SOVEREIGN DOLLAR BOND RETURN 2008
2009
2010
2011
2008-2011
EMBI Global Index Total Return
-10.91%
28.18%
12.04%
8.46%
8.48%
Treasury Return
18.01%
-8.3%
6.71%
13.49%
6.72%
Credit Return
-24.51%
39.88%
4.99%
-4.43%
1.64%
Source: JP Morgan, Western Asset Management
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The anticipated loss from default is the probability of default multiplied by the expected loss from default
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Alpha: US dollar EM sovereign bonds For investors in EM dollar sovereign debt to secure returns that are superior to the index, it is important to be able to distinguish bond issuers whose credit credentials are improving from those whose debt-servicing ability is deteriorating. Selecting which country to invest in and which to avoid – or short – is the main way in which active managers can distinguish themselves from the index. A recent study from the International Monetary Fund illustrates the importance of issuer selection in the EM bond markets. In a regression analysis of the returns of all major EM sovereign bond markets over 2002-2007, the study found that country-specific developments were just as important as external factors such as Treasury yields in driving the risk premiums on such securities lower.4
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Emerging market spread compression: Is it real or is it liquidity? International Fund Working Paper, January 2008
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Changes in the monetary policy expectations were captured by the yield on three-month Fed futures contract and the volatility of Fed Funds futures. To measure the volatility of the Fed Fund Futures market, the study calculated the difference between the implied yield of the three-month Fed Futures contract and the Fed’s daily target rate. The volatility is then the standard deviation of the difference calculated over a rolling 90-day period. For a full discussion of the methodology used, please see http://www.imf. org/external/pubs/ft/wp/2008/wp0810.pdf
Emerging market debt – dollar or local? | October 2012
It found that almost 50 per cent of the reduction in individual sovereigns’ bond spreads that occurred over this period was attributable to improvements in each country’s credit credentials; the remaining 50 per cent was attributable in varying degrees to changes in global risk appetite – the VIX Index – and shifts in US monetary policy expectations.5
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Treasury yields. A steady drop in local bond yields has been responsible for a large part of EM bond investors’ total return over the last decade. One of the most potent forces bearing down on local bond yields over that period – and one that can be expected to endure – is disinflation across the developing world (see Figure 6). Many EM countries are now both better equipped and more willing to bring inflation under control than at any point in their history, be it through monetary policy, deregulation or labour market reform. As a result, there is plenty of scope for both real and nominal local currency bond yields to fall further and eventually converge with yields in developed bond markets.
Beta: Local currency EM bonds The investment returns of local currency bonds – carry aside – come via two routes: capital gains that stem from a drop in bond yields and currency appreciation. Capital gains Much like developed government debt markets, the level and trajectory of yields on local currency EM local bonds are influenced chiefly by domestic factors such as inflation trends and changes in a country’s monetary and fiscal policy. Local currency bond yields are not especially sensitive to changes in the creditworthiness of the issuing sovereign, nor are they influenced to any great extent by moves in US
FIGURE 7 – THE SECULAR DECLINE IN EM INFLATION % 100
% of EM countries with double digit inflation rate
90 80 70 60 50 40 30 20 10 0 71
73
75
77
79
81
83
85
87
89
91
93
95
97
99
01
03
05
07
09
11
12
Source: Pictet Asset Management
Based on the unhedged returns delivered by the JP Morgan GBI-EM index over the period 31.12.2001 – 30.09.2012. Source: Pictet Asset Management 7 The theory was developed by the economists Bela Belassa and Paul Samuelson in 1964 6
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Currency appreciation Choosing to invest in local EM bonds inevitably leads to a decision on whether to hedge or embrace the currency exposure that comes with such securities. Some investors balk at the prospect of currency volatility as gyrations in the foreign exchange markets can at times weigh heavily on the returns of an unhedged fixed income portfolio. That said, currency appreciation has been a key source of return in local EM bonds over the past decade, accounting for around a quarter of the asset class’ total return.6 (See Figure 8.)
This pattern is likely to persist into the future. The appreciation of EM currencies is a structural phenomena – one that stems in part from what is known as the BalassaSamuelson effect.7 This powerful theory explains how countries experiencing enduring improvements in the productivity of their export industries see an accompanying rise in their real exchange rates. In contrast to their developed counterparts, emerging markets are witnessing rapid productivity growth in their export sectors, driving up wages in these industries relative to areas of the economy that
are domestically-oriented, such as services. To close this gap, pay in domestic sectors will also rise, driving prices and real exchange rates higher.
Figure 9 illustrates the productivity gains EM countries have enjoyed compared to the US since 1995.
FIGURE 8 – COMPONENTS OF RETURN: LOCAL BOND MARKETS Historical data: 31.12.2001 – 30.09.2012
% 200
Bond return
180
FX return
160 140 120 100 80 60 40 20 0 Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
Dec-10
Dec-11
Source: JP Morgan GBI-EM index
FIGURE 9 – EM AND US PRODUCTIVITY GAINS % 8.0
7.4
1995-98 2005-10
7.0 6.0
5.5
5.0 4.0 3.1
2.8
3.0 1.8
2.0
1.8
1.8
1.0 0.0 -0.2 -1.0
Asia Ex-Japan
Latin America
EMEA
United States Source: Pictet Asset Management
Emerging market debt – dollar or local? | October 2012
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have plenty of scope to evaluate and capitalise upon shifts in relative valuations among both the currencies and yields in local emerging market bonds – during both market rallies and sell-offs.
Alpha: Local currency EM bonds Country and currency selection There is much potential for skilled active managers to secure above-index returns in local currency EM bond markets. As the market has matured and the domestic investor base has grown, local currency bonds have become more sensitive to domestic factors such as changes in monetary and fiscal policy than ever before, and it is this attribute can be expected to provide a valuable source of excess return. The economic cycles of these countries do not move in lockstep, at any one point in time one country may be easing monetary policy while another might be doing the opposite. Indeed the correlation between any two of the major regions represented in JPMorgan GBI-EM (Broad) local currency bond index is on average below 0.6.8 This means investors
As Figure 10 shows, while currency weakness was a prominent feature for local currency emerging market debt in 2011, total returns delivered by the underlying bonds were positive, partly because policymakers across the developed world signalled a shift to a looser monetary policy to support economic growth. This pattern of returns highlights why the two key sources of local EM debt returns – currency and interest rates – are best managed separately in any investment process.
FIGURE 10 – BREAKDOWN OF RETURNS FOR LOCAL EMERGING MARKETS DEBT IN 2011 Turkey Hungary South Africa Poland Chile Mexico Thailand Russia Malaysia Brazil Philippines Colombia -25
-20
-15
-10
-5
0
5
10
15
20
Currency return, % Local bond return, % Source: JP Morgan
8
Based on correlations of returns from 31.12.2001 – 31.08.2012 for following regions in the JP Morgan GBI-EM bond index: Asia, Europe, Latin America and MENA (monthly observations). Source: JP Morgan/HSBC/Bloomberg
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FIGURE 11 – SOURCES OF RETURN - EM LOCAL BONDS Principal Return Local Currency
% 25
Interest Return Local Currency
FX Return USD
20 10%
15 10 5 0
11%
9% 8%
6% 7%
6%
5%
5%
11% 7%
6%
7%
2%
3%
3%
7% 4%
0%
-4%
0%
7%
4%
-5
7% 2%
4% 4%
-9%
-14%
-10
1%
-15 -20
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012 YTD
Source: Pictet Asset Management
Duration and curve strategies Moreover, as local currency bond markets continue to expand and deepen, the range of investment strategies available to investors to secure above-benchmark returns through interest rate-related investment strategies can be expected to be as broad as that available in developed markets. Hungary, Poland, Mexico, Turkey, Indonesia, and Brazil have already built full, liquid yield curves comparable in size and depth to those of many advanced economies. It is in these markets that duration and curve strategies — tactical decisions that allow investors to express a view on both the general direction of rates and the shape of the yield curve — can be deployed to good effect.
Emerging market debt – dollar or local? | October 2012
In Brazil, for instance, a string of interest rate cuts in the 12 months to September 2012 caused yields on shorter-maturity bonds to fall by a greater margin than those on longermaturity bonds. This widening of the gap between short- and longterm rates, commonly referred to as a steepening of the yield curve, is a shift investors can exploit. By anticipating such a move through simultaneously being underweight longer-maturity bonds and overweight shortermaturity debt, investors would have secured a payoff.
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Risk, return and correlation
Both US and local currency bonds can diversify a portfolio’s sources of return and risk. While the credit crisis has caused many previously uncorrelated asset classes to move in lockstep with one another, both subsectors of EM debt have maintained their historically moderate correlations with most mainstream securities, particularly developed market fixed income, as Figure 12 shows. Local currency debt exhibits especially low correlations with developed market bonds such as US Treasuries and corporate investment and speculativegrade debt. US dollar sovereign EM bonds, meanwhile, stand out as having a moderate correlation with both US and emerging market stocks.
From a risk return perspective, US dollar and local sovereign bonds have both delivered better risk-adjusted returns than the vast majority of mainstream asset classes over the last decade, chiefly because investors have experienced moderate to low levels of volatility. That said, US dollar bonds have been markedly less volatile than their local currency counterparts. Because US dollar sovereign bonds do not incorporate currency risk, their volatility has been very low, similar to that of US investment-grade debt. The currency risk inherent to local sovereign bonds, meanwhile, has raised the asset class’ annualised volatility to around 12 per cent, higher than that of global high-yield bonds.
FIGURE 12 – CROSS ASSET CORRELATIONS9
Correlations EMD local currency debt
Commodities
US government bonds
Investment grade bonds
Global high-yield bonds
EM stocks
S&P 500
Russell 2000
0.75
0.51
0.09
0.45
0.62
0.77
0.62
0.60
1
0.41
0.22
0.55
0.74
0.69
0.59
0.53
1
-0.17
0.21
0.48
0.61
0.43
0.41
1
0.43
-0.24
-0.25
-0.34
-0.35
1
0.41
0.30
0.16
0.15
1
0.72
0.7
0.69
0.82
0.79
EM local currency debt
EM USD debt
1
EMD USD debt Commodities US government bonds Investment grade bonds Global high-yield bonds
1
EM stocks
Source: PAM Fixed Income
1
S&P 500
0.91 1
Russell 2000
FIGURE 13 – RETURN AND VOLATILITY9
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Data taken from monthly observations of following indices covering period 31.12.2001 – 31,09.2012: JP Morgan GBI-EM Global index, Barclays Capital US High Yield 2% Issuer Capped index, S&P 500 index, Russell 2000 index, MSCI EM Equity index, JP Morgan GBI index, S&P GSCI Commodities index, Barclays Global Aggregate Bond index
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Emerging local bonds
Latam local bonds
Emerging Emerging Investment US govGlobal USD local Asia local grade USD ernment high yield Emerging Commodi- Russell bonds currencies bonds bonds bonds bonds Equities ties 2000
Annualised Return
13%
12%
11%
8%
8%
13%
6%
10%
14%
7%
5%
2%
Annualised Volatility
12%
13%
9%
8%
7%
8%
5%
10%
25%
19%
21%
16%
Sharpe Ratios
0.95
0.74
0.97
0.72
0.93
1.38
0.72
0.75
0.46
0.27
0.13
-0.01
S&P 500
Conclusion
The US dollar EM sovereign bond market comprises an extremely broad range of developing countries that are at various stages of their economic development. It is a subsector of EM debt that is characterised by a reasonably wide dispersion in the rating quality of individual issuers. For investors who see the benefits of exposure to fast-growing emerging markets but are wary of the volatility of both stocks and currencies, USD-denominated sovereign EM bonds represent a more conservative way of gaining exposure to the investment opportunities available in the developing world. For fixed income investors, meanwhile, the asset class is a ‘spread’ product that can potentially diversify a portfolio of developed market fixed income securities.
By contrast, the local currency EM bond market is formed of a select group of the most economicallyadvanced emerging markets, those with robust institutions and sophisticated domestic capital markets. It is a market that carries a high investment grade rating and one in which returns stem in large part from country-specific factors that influence both the level of bond yields and the trajectory of currencies. For those investors who are bound by strict credit ratings investment criteria or those who require a combination of higher yields and greater currency diversification, local currency emerging market debt can be an suitable investment option. The currency component of the asset class offers investors an attractive way to capitalise on the increasing economic might of the developing world but with lower volatility than emerging market stocks.
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Emerging market debt – dollar or local? | October 2012
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