Are emerging market (EM) nations a better credit risk than western countries? As the FT’s very own John Authers recently noted, there is now a sizeable group of institutions that reckon the answer is “yes”.
If we accept this logic – which I don’t – then the traditional spread between the yield on supposedly safe US debt and “dodgier” Indian, Chinese or Arab debt might actually turn negative over the next few years. If that were to happen, so that EM sovereign debt yielded less than US Treasury bonds, it would be nothing short of a revolution.
Back in the twilight years of the last century, the yield spread could be measured in the hundreds, if not thousands, of basis points. In some cases it’s now down to under 300. Not that most of us would have noticed this. Traditionally, it was only bond investors who worried about the spread over US Treasuries. Most ordinary investors played the EM growth story via equities. But, in the past year especially, some investors have started to diversify, mixing their EM exposure between equities, debt and currency plays.
Their reasoning is quite simple. Equities can be hugely volatile, especially in places such as China, while bonds tend to be less volatile and produce a very decent income yield.
But there’s another twist.
Bonds can be issued in supposedly hard currencies – dollars and euros – as well as local currencies. Up to now, much of the stampede into EM debt has been into hard-currency denominated bonds, pushing yields to historic lows. However, according to the experts, some local-currency debt markets (India and Brazil stand out) represent much better value in yield terms with roughly similar risk ratings – and you may also make money if the FX rates move your way.
This blending of debt denominations is now being practised by the managers of increasingly popular emerging market debt funds.
Until fairly recently, fund investors didn’t have much choice, beyond the easy-to-access iShares exchange traded fund (ticker symbol SEMB), which simply tracks the JPMorgan index of EM debt.
But why track an index that comprises bonds from countries with the most debt in circulation? Why not buy bonds in the countries (and companies) with the least debt, and the best financial position?
That’s the idea behind the Stratton Street stable of hedge funds which includes an Asian Bond fund, a Renminbi fund and their Wealthy Nations Bond fund run with private bank ECG. Stratton Street uses a fundamental analysis of the net foreign assets of a country and then focuses its buying.
Other funds offering EM debt exposure include the London-listed Ashmore Global Opportunities Fund and a new fund from Investec (see box below).
Would I buy any of these funds? Yes, but not because of the big narrative that EM states are more solvent than we are. The supposedly strong financials of countries in the Gulf Co-operation Council or Russia (both favoured by Stratton Street, for instance) could crumble overnight if oil prices tanked. Another worry is that even diversified economies such as China are much more vulnerable to hidden problems than the bulls maintain. Academics such as Michael Pettis in Beijing point out that China’s off- balance-sheet liabilities at the local level are huge and growing by the day.
Also, all this talk of a one way trade in currencies like the renminbi is just that . . . talk! Experienced China equity hand Chris Ruffle from Martin Currie reckons that China could move into a trade deficit within years, with an inevitable currency hit.
And EM states regularly default: in 2008, ratings firm Moody’s identified 12 different defaults within the EM space. So much for the idea that EM sovereign debt is safe!
No, I’d look at this space for simple diversification reasons. If you do buy into globalisation, don’t make the lazy assumption that it will only ever be captured by equities. You need some bond exposure, preferably involving a mix of local and hard currency plus sovereign and corporate.