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Strength of emerging debt

Emerging markets have become the dominant investment theme and there are some experienced teams in the market playing this through bonds rather than equities.

Interest in this area is on this rise, with several strategic fixed-interest managers upping their allocation with developed market credit expected to produce more modest returns.

Investec’s Peter Eerdmans heads the group’s emerging debt team, marked out by its long-term focus on local currency bonds as opposed to dollar-denominated.

Eerdmans has run the £630m emerging markets debt fund since launch in 2006, highlighting the group’s credentials in this market – investing in South African debt for over two decades, for example. The team’s process is very much bottom-up, preferring to make money through relative value trades in counties and currencies rather than attempting major macro calls.

“We tend to cover all the bases to generate alpha rather than skewing the portfolio towards single themes like Greece’s current problems,” says Eerdmans. “That tends to means we are often contrarian and early with our calls, and typically have a value bias on the portfolio.”

Each country and currency is scored on a regular basis – analysing issues like valuations and fiscal policy – and the team uses qualitative and quantitative measures to build its positions. Eerdmans says many competitors are quick to dismiss quants as a waste of time but the team’s currency model now boasts a successful track record going back to 1998.

Like most GEM equity managers, Eerdmans’ is strategy is founded in a positive view of the region’s long-term prospects compared with the debt-burdened West.

Playing local currency bonds in the region also provides a potential double source of returns if emerging markets outperform, as yield and currencies will both converge to developed status.

“These bonds potentially offer equity-like returns with half the volatility of emerging stockmarkets,” says Eerdmans. “The current fiscal situation in most emerging countries is exceptionally strong – with debt-to-GDP ratios of around 40 per cent compared with 100 per cent in the West – meaning we can be confident on credit quality. Despite all this, emerging debt markets are still yet to fully price in this major fiscal strength.”

Investec’s fund largely invests in sovereign paper at present, with just 3 per cent in the region’s credit, although Eerdmans is expecting the latter market to develop substantially in the coming years.

He currently sees credit in the region as a hard currency play and feels many local markets remain expensive, believing it is still early days for more comprehensive investment.

On the bond side, the team has been taking profits on several of its long ideas, recognising we are now at the back end of a strong run for emerging debt. They have moved long positions in countries including Turkey, Indonesia and Hungary to neutral in recent months, having benefited from a rally in markets running through last year.

“We have also moved from a year long to neutral duration after the great run in markets, with inflation now rising and interest rate rises on the cards,” he adds. “While there are more headwinds, we have not gone short duration as the market has already priced in higher inflation and rate hikes than we expect.”

After the strong run last year, he sees 2010 as back to a relative value environment, with a current short Peru against long Colombia position in place for example. Apart from a nice yield pick-up from this trade, the bet is also based on a view that the Colombian central bank is in a position to start its rate-tightening cycle at a later stage.

Meanwhile, on the currency front, the fund was largely neutral during the first half of last year but has more recently moved into areas sensitive to the region’s growth.

“While the bond market looks set for a coupon clipping year in 2010, currencies are benefitting from additional fund flows into emerging markets as developed issues continue,” says Eerdmans.

Overall, the portfolio is currently overweight Asian currencies, which generally lagged the rally and are still reasonably priced.
Eerdmans is also expecting China to allow the renminbi to appreciate this year, which should be positive for free-floating currencies in the region.

Among the short positions, Investec is currently negative on the Brazilian real, seeing it as expensive.

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