Riding the crest of a wave, but beware of any undertow

Perhaps there has been a propensity to underestimate the role that solid institutional frameworks (incorporating, for example, a country's legal system, the rule of law and property rights) have to play in contributing to the (lack of) underlying risk in an investment. Studies² have shown that during volatile times, both international investors and portfolio capital are more likely to rush in and out of countries in which institutional frameworks are somewhat opaque. There is evidence that during a crisis, international investors tend to flee these more opaque markets in greater volumes. This suggests that an increase in transparency can be an effective way for countries to benefit from international financial integration, while avoiding excessive volatility during turbulent times. It is debatable how much of the recent inflow of funds searching for yield premium within emerging-market government bonds is actually attributable to long-term holders of the asset class. It has been suggested³ that ‘hot money' (in search of short-term opportunities) is likely to be even more averse to opaque institutional frameworks.

The average credit rating of the JP Morgan EMBI+ Index is BB+. As at 25 October 2010, the spread over US Treasuries was 257 basis points. By contrast, the average spread of the BB+ portion of the Merrill Lynch H0A1 US High Yield Index was 409bps.

The total market capitalisation of the hard currency debt across three commonly used emerging-market bond indices, namely the JP Morgan EMBI+ and EMBI GD indices and the Merrill Lynch Global Sovereign Emerging Plus Index, totaled $470.66bn at 25 October 2010. The market capitalisation of the Merrill Lynch US High Yield Index, which excludes euro and other major currency-denominated high-yield corporate bond markets, by comparison, was $994.1bn.

There is of course the argument that default rates among emerging market sovereigns and among similarly rated corporate debt are different from one another. However, for sovereigns rated ‘Ba' by Moody's, which is roughly the same grade as the average of the EMBI+ Index, the one-year default rate at 25 October stood at 0.832%, while for corporate bonds, the figure was 1.17%.

If we simply apply this ratio of default rates (i.e. 1.17%/0.832%) between the two asset classes, and multiply this ratio by the 257 basis-point spread (quoted for the EMBI+ Index), a case could be made that, all things being equal between emerging-market sovereign and corporate issuers, BB+ rated high-yield corporate securities should yield 361 basis points over US Treasuries, as opposed to the actual prevailing spread of 409 basis points. That is not to make light of the increased ‘event risk' faced by companies compared with sovereign issuers. However, we believe the maths suggests that, within the context of well-diversified bond portfolios, high-yield corporate bonds may be attractive at present. We consider, owing to their relative valuation attractions, that Western corporate bond markets may soon become benefi­ciaries of portfolio capital inflows as the ‘search for yield' continues.

The recent performance of emerging-market economies has challenged the findings of studies such as the one to which we refer above,⁴ as emerging economies have weathered the recent financial crisis well, despite some of the governments in question scoring poorly on various transparency indices.

This scenario may well continue, as we currently have three market conditions that are generally conducive to a tightening of emerging-market spreads:

If we do indeed 'bumble along' at record low interest rates, with insipid growth rates in Western economies, but strong commodity demand from growing Asian economies, then the yield pick-up (premium) on emerging-market debt should remain attractive.

A simple comparison of the list of emerging-market issuers in recent years provides us with an idea of the growth in numbers of hard currency (i.e. stable, quality currency) sovereign issuers. Similar to the present situation, capital in the latter half of the 1970s had followed the search for yield into emerging-market economies. Emerging-market governments issued bonds aggressively in US dollars in the late 1970s to take advantage of low funding rates (US interest rates were cut from 13% in mid-1974 to 4.75% just two years later), owing to the demand for emerging-market bonds, coupled with low interest rates in developed world economies.

Figure 2 shows the levels of global foreign direct investment during the 1970s and early 1980s.

Recent emerging-market economic performance does little to endorse the relevant concept of 'reputational credit'.⁵ The standard reputational argument as to why governments repay debt is that they fear that in the event of default, their tarnished reputations will affect future debt relationships adversely, and make creditors less willing to lend to them. A strong reputation in credit markets can support the accumulation of large amounts of debt. This was found to be true in both the US and the UK in the aftermath of the financial crisis. The US and UK governments were able to issue enormous amounts of debt to help maintain confidence and liquidity in their financial sectors, to allow them to continue to function. The collateral for this debt was mainly confidence in the reputations of the US and UK governments. In the case of developing nations, this is a crucial factor because, if the rate of a country's economic growth does not exceed the rate of growth in its debt, at some point the debt will have to be refinanced in order to avoid a debt default.

This is not to suggest that a wave of imminent defaults is expected within the EMBI+ Index. We must recognise, however, that for the dedicated investor in emerging-market government bonds as an asset class, rather than in individual assets, the (higher-quality) investment-grade component of the Index may well fall in the period ahead, because a number of investment-grade sovereigns will graduate from the EMBI+ Index into the World Government Bond Index (WGBI). For example, Mexico is scheduled for ‘promotion' to the WGBI in the near future, and when this happens the credit quality of the EMBI+ Index will, logically, be reduced, as one of the larger-weighted, higher-rated governments leaves that index. We could reasonably expect this scenario to continue in the future as liquid, similarly rated, large market-cap investment-grade issuers such as Brazil meet criteria for inclusion in the WGBI.

The issue of reputational credit has become more relevant owing to recent ‘currency wars', a term which refers to widespread competitive currency devaluations and interventions to halt the appreciation of currencies against the US dollar. Intervention in markets in various guises will increase the probability of policy error. In the case of a realisation of flawed emerging-market economic policy, we could reasonably expect a loss of confidence in local currencies, which would make hard-currency debt obligations more expensive. It is therefore reasonable to make comparisons with events of the early 1980s, when hard-currency borrowing splurges, and the concurrent weakening of local currencies, were causal factors behind a spate of emerging-market government defaults in 1982-83. Without a ‘safety-net' reserve of reputational credit, refinancing and the restructuring of debt obligations may become prohibitively expensive.

That is not to understate the advances and improvements in transparency made within recent years among emerging-market issuers; however, the attainment of reputational credit can be summed up by the following quotation:

"The fact that a country is democratic today makes just about no difference to how corrupt it is perceived to be. What matters is whether or not it has been a democracy for decades. The regression estimates a painfully slow process by which democracy undermines the foundations of corruption."

A key attraction for investment in emerging-market government issues is their relatively low debt-to-GDP ratios, compared to many of the WGBI bond issuers. However, an increase in levels of issuance is likely to erode this value. We would also question the strategic validity (other than to take advantage of what are currently believed to be fantastically low yields) of issuing 100-year debt, as was recently the case in Mexico and is now being considered by Egypt.

As stated above, if the status quo of the world economy remains, for the near future, in place, emerging-market assets should represent a valid ‘buy and hold' approach to ‘pick up' increased yields at a reasonably low risk in relation to higher-quality sovereign bonds. However, we believe that the pick-up in yield achieved by holding similarly rated corporate bonds in more developed jurisdictions presents a more attractive proposition, when we take into account factors such as market size; at some point the relative value of investing in assets domiciled within countries with solid institutional frameworks should halt the rush towards emerging markets. We should also recognise that if the strong inflows to emerging markets indeed constitute a bubble, further ‘quantitative easing' (money creation) by central banks in the major Western economies will do little to bring about an orderly ‘deflation' of the situation.