Investors are viewing emerging market debt in a new light as concerns increase about the creditworthiness of sovereign debt in the developed world, particularly in the eurozone.

Net inflows into emerging market debt totalled $30.6bn (£20.7bn, €25bn) from the beginning of the year to late May compared with $33bn for the whole of 2009, according to JPMorgan.

“There is recognition that emerging market balance sheets are strong and the debt to GDP ratio is below 40 per cent compared to the western world, where it is over 100 per cent in many countries,” says Sam Finkelstein, head of emerging market debt at Goldman Sachs Asset Management.

Inflows are coming from institutional and retail investors, sovereign wealth funds and central banks, experts say. Pension funds are also showing interest in the asset class, seeking to diversify portfolios.

“We have seen a steady stream of demand from pension funds for emerging market debt over the past 18 months and we expect this to continue.” says Matthew Roberts, an investment consultant at Towers Watson. “Investors are taking advantage of economic growth and opportunities in emerging markets.”

This is a “long-term rather than opportunistic interest”, he adds.

Pension funds traditionally invest in dollar denominated government bonds as they perceive local currency bonds are riskier, but many fund managers favour local currency debt. “Local debt is where the opportunities are. Yields in local bonds are more attractive [than hard currency] but it is necessary to select country by country,” says Xavier Baraton, global chief investment officer for fixed income at HSBC Global Asset Management. He currently favours local currency bonds in Latin America and Asia.

Emerging market debt makes up almost 20 per cent ($8,200bn) of total global bond market capitalisation ($40,700bn) with the majority coming from local currency emerging market bonds ($6,800bn), says Chris Gower, head of European consultant relations at HSBC Global Asset Management.

“We are seeing equal demand from pension funds in the US and Europe. They are beginning to allocate to EM debt in the US but European pension funds are looking for the next opportunity in local debt,” says Mr Baraton. One European pension fund invested over $100m in one day, he adds.

Jerome Booth, head of research at Ashmore, the EM specialist asset manager, expects to see “big flows come into local debt” as pension funds “slowly shift perspective” to emerging market debt. Larger institutional investors head to local currency sovereign debt, while medium-sized ones stay with dollar denominated debt, he says.

Mexico and Brazil offer the highest yields on local currency sovereign debt, while Russia offers high yields on dollar denominated and local currency bonds. Mr Booth likes both on the basis of the economy being resource-rich and risk of default relatively low.

Mr Booth estimates about 80 per cent of returns from local currency debt come from currency movement. “Emerging markets are largely surplus countries today so their currencies are not so unstable [as in the past].” He believes the big currency risk is in “euro, sterling and dollars”, not in emerging markets.

However, some asset allocators have doubts about pension funds’ current interest in the asset class. While an increasing number of clients are asking about “more and more esoteric parts of emerging markets such as local debt and private equity, we are negative on emerging market debt, seeing it purely as a trend”, says Colin Robertson, head of asset allocation at Hewitt, a consultancy.

He agrees the quality of economic management has improved in emerging markets but spreads are lower than previously. “Back in 2000, spreads over treasuries were over 10 per cent but in May were down to 3.5 per cent, while the historic average is about 4 per cent,” he says.

Mr Robertson also questions whether investors look closely at the poor quality of countries that make up the components of emerging market bond indices such as the JPMorgan EMBI, with Mexico, Brazil, Russia, Turkey and Venezuela among the top 10 bond weightings.

While it is “reasonable to have long-term strategic exposure to emerging market bonds, for us as medium-term allocators it does not stack up”, he says.

Among the risks are inflation followed by sovereign debt default and political risk. “We are monitoring inflation and the impact of inflation in Europe on the sector,” says Mr Baraton. “We watch central banks’ decision making and the risk of economic slowdown, particularly from the eurozone,” he says.

Mr Jerome says the vast majority of emerging market countries “have the tools to tackle inflation and will succeed, having reasonable independence from their central banks. India and Indonesia have voted reformist governments back in [to tackle inflation] and we are seeing positive action in Colombia.”

However, some of the appeal of emerging market debt disappeared in May, which was not a good month for many asset classes as risk aversion took hold due to the debt crisis in Greece and the European Union’s €750bn bail-out package.

The JPM GBI EM dollar denominated index was down 3.7 per cent from the beginning of May to June 17, although the local currency index fared better, returning 1.1 per cent.

Some fund managers have already reduced exposure to emerging markets, betting on a big fall in prices. HSBC’s Mr Baraton observes that “repricing is good news and was necessary”.

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