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Change of perception

Emerging markets may have emerged in many investors’ minds but the debt of these countries still retains the perception of being high risk.

The recent wariness towards sovereign debt in general has not helped, but just as emerging economies have differed from the west in terms of their overall health so too does the attractiveness of their government debt.

Considering the continued interest in bond markets, emerging market debt may be a good diversifier to portfolios – if it can overcome its high-risk reputation.

Baillie Gifford manager of emerging market bonds Sally Greig says, only a decade ago, this area of the market saw huge volatility and defaults but the world has come far since then, with even the perception of what is an emerging market changing.

There are not many ways for UK retail investors to access this asset class, with less than a handful of onshore funds available. Many global bond funds may use emerging market debt in their asset allocation but the few dedicated funds include Investec emerging markets debt, Threadneedle emerging market bond and the Baillie Gifford portfolio. Schroders also has an emerging European debt portfolio in the IMA’s global bond sector.

Performance on these dedicated vehicles has held up well through the volatile past few years. Over three years to April 14, the Investec fund is not only a top performer in the global bond sector but is also ranked second best performing fund across the entire Oeic/unit trust universe on the back of 87.2 per cent gains, according to Trustnet figures. Over one year, emerging market debt fund performance is in line with the rest of the global bond sector, but over the shorter six-month period to end of March they are all at the top of the sector with returns ranging from 10 to 15 per cent.

Among the funds on offer there is a bias towards local currency emerging market debt. The advantage of local currency bonds can be its greater stability. If a country’s currency devalues it can become difficult to pay off a foreign loan, while those bonds denominated in the country’s own currency are easier to pay back, says Greig.

Investec head of merging markets debt team Peter Eerdmans notes in recent years that local currency debt trading levels have overtaken dollardenominated debt in emerging markets, a trend the group expects to continue.

He says: “We think local currency debt markets offer attractive yields as well as great potential for additional returns through further yield compression or currency appreciation.

“As emerging markets travel the path from emergence to development, their currencies are likely to strengthen. While currency exposure brings additional risks, we believe these are compensated for by commensurate potential returns and diversification.”

Over the past 15 years, from December 31,1993 to September 30, 2009, local emerging market debt has returned 10.9 per cent a year in US dollar terms with only 9.5 per cent volatility (standard deviation based on monthly returns). This compares with dollar debt returns of 10.4 per cent with a volatility of 13.8 per cent.”

Many of the portfolios accessing the local bond markets also offer the ability to make gains on the currencies themselves. The Investec fund holds currencies direct and Greig says that currency plays within the Baillie Gifford fund have added about half of the gains made in the portfolio over the past year. Analysts at Danske Markets also note that the emerging market currencies have performed well of late. In particular, Asian currencies strengthened over March with the Turkish lira one of the best-performing currencies.

Although the risks of emerging market sovereign debt have decreased significantly in recent times, the risk premiums being paid remain high. The credit quality of a lot of the sover-eign debt Greig looks at in the emerging areas is BBB+ and above. She says 10 years ago, it is likely it would have been considered to be sub-investmentgrade. And while the default risk of these countries is not non-existent, it is lower than it once was.

“You could argue emerging markets are a safe haven. With regard to debt to GDP, it is less than half that of many developed markets,” she says.

Greig points out that EM local bonds are on average yields of 7.2 per cent compared with 2.1 per cent for emerging market equities and 2.8 per cent for developed bonds. At the same time, volatility for the asset class is scored as 10 versus 21.2 for emerging market equities and 7.3 for developed bonds.

With improved quality and attractive yields, there is also improved demand. Domestic insurance companies, pensions and sovereign wealth funds are all growing buyers of emerging sovereign debt, says Greig.

Despite the rosy and enthusiastic outlook from managers in this area, they all agree the emerging sovereign market still has issues.

onsidered an immature market and one exposed to a lot of short term investors, the main index Greig uses is just eight years old.

“There are plenty of opportunities in these markets but you need patience and a longer-term time horizon. For us, as long as the fundamental case for holding the bonds is sound, we are happy to hold on even through the noise and ride out any short-term volatility,” she says.

Threadneedle says there are a number of positives for the asset class right now, with local currency issues looking particularly attractive.

Economic fundamentals remain very supportive for most of these markets and investor risk appetite has greatly benefited the asset class.

Within the onshore EM debt portfolios, Threadneedle, Investec and Baillie Gifford all appear to be favouring Hungary at the moment. Beyond this, Investec’s biggest weighting is to South Africa, followed by Mexico and Brazil. Baillie Gifford favours Poland and Brazil, while overweight positions for the Threadneedle fund include Venezuela and Egypt.

Already, many investors are starting to accept that emerging market equities are a long-term story, the risks of which are lower today than they may have been years ago. With the recent situation in Greece and speculation over the state of other Western economies, it would appear as if perceptions should change with regard to emerging market bonds as well.

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