Rethinking Risk In Global Emerging Markets Debt
By: Raphael Kassin
Despite financial or political crises which bring thoughts of sovereign default, debt restructuring, devaluation, or even political coup to the minds of potential investors, emerging markets fixed income is a viable asset class for institutional investors, says Raphael Kassin, of ABN AMRO Asset Management.
The birth of emerging markets fixed income (in hard currencies) as an asset class viable for institutional investment dates back only to the 1990s. Since then, returns have been amongst the best available, compared to equities and other fixed income, and the asset class has developed to include all types of instruments available in most major markets.
With such an outstanding track record and wide range of investment opportunities available (including derivatives), one might expect to see emerging markets fixed income more widely used in most global diversified portfolios. Unfortunately, since the early 1990s, every couple of years a financial or political crisis has erupted in an emerging country, bringing the thought of sovereign default, debt restructuring, devaluation, or even political coup to the minds of potential investors.
As a result, fearing the next crisis, many have so far chosen to avoid this high risk/return asset class. Since there has been a lot of volatility recently, is now still a good time to invest in global emerging markets bonds?
From a fundamental point of view, most major countries in the emerging markets universe have, in the last five years, reached acceptable levels of stability and are enroute to a better sovereign credit rating. All major countries represented in the JP Morgan EMBI Global have open and fully floating currencies, which is welcomed by the International Monetary Fund.
Fiscal discipline and responsible budgetary behaviour are also becoming prevalent. The result has been respectable macro-economic performance when compared to developed countries, coupled with sustainable inflation levels. Importantly, the continuing stability of oil prices at high levels is also providing strong support for emerging market economies through healthier balance of payments. Lastly, financing needs of emerging market borrowers have dropped and are being well met by demand for risky assets, eliminating a potential source of imbalance.
Thus, when we compare the state of emerging economies now to 1997 (pre- Asian and other various crises), the aggregate spread level of the EMBI Global should be lower than 330 basis points over U.S. Treasuries – the lowest spread, observed in 1997. Nonetheless in mid-May 2004, the spread of the EMBI Global was near 500 basis points over U.S. Treasuries.
Considering the fundamental improvements in the countries and a now higher proportion of emerging debt rated investment grade (45 per cent now versus 20 per cent in 1997), one should expect to see the spread tightening at least through the 330 bps mark.
Against this background, our question is not whether investors should have an allocation to hard currency emerging bonds in their portfolios, but instead how much that allocation should be.
To take a quantitative approach to this question, we can look at asset classes available to a multi-asset investor. We can then compare the quantitative output with our fundamental outcome to see if the results match.
Using ex-post risk/return data from the period January 1991 to April 2004, it is interesting to find that emerging markets bonds (in terms of risk) are positioned together with equities and not bonds (Chart 1).
In terms of the Sharpe ratio, emerging bonds also look relatively attractive, comparable to investment grade bonds, high-yield bonds, and hedge funds (Chart 2).
Thus, our first result shows that emerging markets bonds are attractive as an investment (high Sharpe ratio) and that they have historically been positioned close to equities in terms of risk. Should that be enough to convince long-term investors to dip their toes into the asset class? The answer is ‘partly.’
It is also important to know the point of reference of the investor. In this case, we consider the starting point to be the portfolio of an investor with 50 per cent in Canadian equities and 50 per cent in Canadian fixed income. To measure the optimal allocation to emerging markets bonds by this typical investor, we have built an efficient frontier starting with the assumed 50/50 asset allocation with 10-year data ending in April 2004.
Adding emerging bonds to the base case balanced portfolio (50 per cent Canadian bond and 50 per cent Canadian equity) generates an attractive efficient frontier, with the optimal risk/return portfolio representing 40 per cent in Canadian equities and 40 per cent in Canadian fixed income, and a stunning 20 per cent in emerging bonds. We agree that a 20 per cent allocation to a single risky asset class might sound extreme. However, we believe that in a global context, it is potentially lucrative to consider at least some exposure to this attractive asset class (five to 10 per cent).
So, if emerging market bonds look so attractive on a historical risk return basis, why aren’t they more popular with longterm investors, even though some do invest in similarly risky asset classes such as private and/or emerging equity?
One likely reason why investors shy away from this surprisingly strong performer is concern regarding the volatility and potential loss. As a noted investor once said, “in most cases, it is acceptable to lose 50 per cent in a blue chip stock, but it is not acceptable to lose one per cent in an offindex bet.”
That concern can be reduced when obtaining exposure to the asset class via a reputable manager with a historic record of consistent outperformance. A
nother reason cited for avoiding emerging markets bonds is the fallacy that “if I want emerging risk, I should then buy emerging markets equities.”
As shown in Charts 3 and 4, emerging markets bonds offer risk/return improvement when added to our base case balanced portfolio, while on their own emerging equities and Canadian equities do not.
In fact, on a risk/return basis, emerging equity investors would have actually benefited from investing a percentage of the portfolio in emerging markets bonds. It is easy to understand why. If one envisions emerging markets bonds as an extension of developed sovereign risk, it is easy to understand why emerging sovereign bonds perform in the same countries.
Countries default but do not disappear, while companies’ assets are sold in the event of bankruptcy and the companies usually cease to exist. Furthermore, emerging markets bonds are denominated in hard currencies, which bear relatively low risk when compared to the local currency risk of most emerging markets equities.
Thus, instead of investing one’s whole risky allocation to emerging markets equities, one might consider sharing the exposure in a more balanced manner with emerging markets bonds.
How About Hedge Funds?
At the current point in the global interest rate cycle, it is important to be realistic and accept that downward price risk to any bond portfolio is now higher than it has ever been during the last five years. We cannot escape the facts and should expect more volatility as a result. Thus, instead of allocating to emerging bonds in a long-only basis, it makes more sense to still seek the good returns of the asset class, but now through hedge funds. That way, investors can benefit from both positive and negative market movements in the various countries and still benefit from the good returns available in the asset class. It is comparable to maneuvering a sailboat. When wind conditions change, one must change the position of the sails to continue moving forward.
Raphael Kassin manages ABN AMRO Asset Management’s Global Emerging Markets Bond Fund.
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