30 www.fssuper.com.au Investment Volume 04 Issue 03 | 2012

Yoel Prasetyo, Russell Investments Maniranjan Kumar, Russell Investments

Yoel Prasetyo is a senior fixed income researcher Maniranjan Kumar is a hedge funds portfolio analyst for Russell Investment, where he conducts manager with Russell Investments. Maniranjan is responsible research, mainly in the Broad U.S. fixed income, for assisting senior portfolio manager with daily , currency strategy, and absolute responsibilities, including trade settlement, portfolio return fixed income strategies for Russell’ multi- pricing, fund reconciliation, and liquidity monitoring, manager product suite and consulting client solutions. taking into consideration portfolio weightings and specific goals. He also helps in selection of investments, construction and optimization of portfolios.

The investment case for

Maniranjan Kumar and Yoel Prasetyo proved external debt positions, greater policy autonomy and the more flexible foreign exchange regimes of the constituent economies n 1973, a global oil crisis reversed the traditional flow of have all contributed to the maturing of the emerging market debt capital as oil exporting nations began to accumulate vast (“EMD”) asset class. wealth. Toward the end of the 1970s, their newfound We believe these factors, along with positive supply and demand wealth gave some of these emerging market countries factors and the secular trend of improvements, make emerging the ability to borrow. During the initial years, the market debt appealing as a long-term strategic asset class. borrowings stayed on ’ balance sheets. But after a series of sovereign defaults by many contemporary Rationale for investing in emerging market debt Iemerging market countries, a debt crisis began in 1982. Near the After experiencing painful economic contraction during the Asian end of the decade – in March 1989 – U.S. Treasury Secretary financial crisis of 1997–1998, many emerging market countries Nicholas Brady announced a debt-relief program that would convert adopted a more disciplined approach to managing their fiscal and outstanding U.S. into a variety of new bonds, which monetary policies. Many of these countries fared well during the became known as Brady bonds. global financial crisis that occurred 10 years later. Since then, the emerging market fixed income universe has con- Additionally, long-term prospects are favourable for emerging tinued its expansion. Primary debt issuance has increased, and the markets. With 77% of the world’s population and 75% of its land market has become more liquid. More recently, loan defaults by mass, they are strongly on a long-term growth path (Figure 1). While emerging markets have been rarer, with fewer crises relative to his- advanced economies are aging rapidly, emerging economies have tory. Furthermore, institutional participation increased as the mar- younger demographics, and that is expected to be a huge advantage ket grew, and after the J.P. Morgan Emerging Market Index, in coming decades. In the short term, they are well positioned to ser- designed to cover U.S. dollar-denominated Brady bonds, loans and vice their debt burdens, given that they have 72% of the world’s for- Eurobonds, was introduced in 1992. eign exchange reserves and low debt burdens relative to their GDPs While Brady bonds initially included only dollar-denominated (Figure 2). Many of the emerging market countries have grown debt, more recently, emerging market debt increasingly consists of faster than most developed countries, and they have accumulated re- debt issued by more balanced economies in local currencies. To some serves, reduced their debt-to-GDP ratios, diversified their sources of extent, this reflects emerging economies’ resilience in withstanding economic growth, and adjusted their fiscal and monetary policies to shocks to the global financial system. Reserves accumulation, im- reduce vulnerabilities to economic shocks and contagion.

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Figure 1. Emerging and developed economies as a

Evolution of EMD market Epercentagexhibit 1/ Emerging a nofd dev worldeloped eco total,nomies a sasa pe ofrce nJtaunege of w o2011rld total, as of June 2011

In the 1980s, many less-developed economies defaulted 100% 87% 83% on their sovereign debt held by global banks. In response, 75% 80% 72% 74% U.S. Treasury Secretary Nicholas Brady introduced 63% 64% 58% 60% 52% 54% a new approach to debt repayment, and the securities 48% 42% 47% 40% 37% 36% that emerged were called Brady bonds. The first Brady 28% 25% 26% 17% Plan agreement was signed in March 1990, when banks 20% 13% exchanged Mexican loans for bonds. Later Brady plans 0% were implemented for , , , the Côte d’Ivoire, , Croatia, the Dominican Re- public, , Jordan, , Nicaragua, , Panama, Peru, the , , Russia, Slove- nia, , and Vietnam. By 1998, after Source: CSIS, Schroders, BofA Merrill Lynch, BP Statistical Review of World over a decade of defaults, all major Brady Plan restruc- Energy June 2011, CIA World Factbook 2011, IMF World Economic Outlook turings had been completed, signaling the transforma- 2011, MSCI Data is as of the specified date. Current data may be different. tion of emerging market debt from an unsecuritised loan market to a bond market and paving the way for many former debtor nations to reenter the voluntary global EFxigurehibit 2/ E 2.stim Eatstimateded 2012 Gove 2012rnment NGeovernmentt Debt as % of GD NPet Debt as % of GDP The quote capital markets. 175 The introduction of the Brady Plan increased liquid- 150 The introduction of the ity in the EMD universe. According to the Emerging 125 Brady Plan increased Markets Traders Association, market trading volumes liquidity in the EMD 100 grew rapidly in the 1990s, peaking at $9 trillion in 1997 universe. before falling sharply in response to the Russian 75 in mid-1998.2 Confidence returned to the asset class 50 shortly after, as ’s credit rating was upgraded to 25 investment grade and Russia successfully completed its 0 “London Club” debt restructuring in 1999–2000. By 2007, secondary market trading volumes rebound- ed to about $6.5 trillion, and with the retirement of most Source: IMF, World Economic Outlook Database, April 2011 data is as of the Brady bonds, the share of local market instruments in specified date. Current data may be different. overall EMD trading rose to nearly 66% (Figure 4). As investors sought safer investments during the credit cri- sis of 2008, trading volume fell to $4.2 trillion before EFxhigureibit 3 / Eme rg3.ing mEarmergingket debt timeline market debt timeline Latin Introduction of J.P. Morgan’s rebounding to its highest level ever in 2010: US$6.8 tril- America Russia upgraded EMBI and EMLI indices to investment Brazil upgraded to defaults Asian Argentina grade; 45% of investment grade Financial Brady bonds issued defaults the universe is lion, about 70% in local market instruments. Crisis investment grade In recent years, more sophisticated instruments, in- 1980s 1990 1992-1994 1997 2001 2003 2008 cluding sovereign credit default swaps (CDS) and cor- porate Eurobonds, have become more liquid and ac- 1982 1994 1996 1998 1999 2003 2003-2007 2009 -2011

Russia Mexico - first Development of secondary Credit crunch cessible. According to the Emerging Markets Traders 80% of EMD defaults country to retire market for sovereign and European index is Brady bonds debt crisis EMD loans classified as Association (EMTA), large banks reported US $1.452 below Ecuador Philippines, investment defaults on Tequila Crisis – grade , trillion in EM CDS volumes in 2010. Corporate Eu- Mexican peso Brady bonds Brazil, and devaluation Venezuela retire Brady robonds now represent almost half of all Eurobond vol- bonds umes. Recent developments indicate a larger investor Source: Russell Research Source: Russell Research base, as well as growing confidence among EMD inves- tors (Figure 5). Figure 4. Emerging markets debt trading volume Emerging market debt as an asset Exhibit 4 / Emerging markets debt trading volume 8 class 7

The emerging market debt asset class consists of hard 6 s currency bonds, local currency bonds, Eurobonds, n

o 5 i l l i r traded loans and local market debt instruments issued t 4 $ S by sovereign, quasi-sovereign and corporate entities of U 3 emerging economies. The universe does not include 2 borrowings from governments or international financial 1 institutions such as the IMF, although loans that are is- 0 1994 1998 2002 2006 2010 sued in the market and securitised are included. Brady Bonds Non-Brady Eurobonds Loans Local Currency Instruments Derivatives Source: Emerging Markets Traders Association Source: Emerging Markets Traders Association

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There is no consistent definition of what makes a coun- Figure 5. Development of the EMD market try’s market “emerging.” While some countries, such as Exhibit 5 / Development of the EMD market Brazil, Chile, China, India, South Africa, Turkey, etc., CDS, Longer are currently universally acknowledged as emerging, Bank Brady Eurobonds Global EM options, Local duration loans bonds / Yankees bonds corporate and FX markets local definitions of others are more discretionary. For in- derivatives markets stance, the FTSE Group classifies emerging markets on

1980s 1990s 2000s the basis of national income and the development of the Source: EMTA and Russell Research market infrastructure, whereas S&P classifies a market Source: EMTA and Russell Research as emerging on the basis of national income, financial depth and the existence of discriminatory controls for non-domiciled investors, and on factors such as trans- parency, market regulation and operational efficiency. Figure 6. J.P.Morgan EMD indices as of December 31, 2011 Indices / Benchmarks Hard Currency Sovereign Hard Currency Corporate Local Currency Bonds J. P. Morgan’s emerging market debt indices are the most Benchmark Emerging Markets Bond Corporate EM Bond Index Government Bond Index commonly used benchmarks for the EMD asset class. Index (EMBI GD) (CEMBI Div) (GBI-EM GD) Figures 6 and 7 list of some of the most commonly used J. Benchmark Description USD-denominated debt USD-denominated Liquid, fixed-rate of sovereign/quasi- debt issued by local currency debt P. Morgan indices and the assets benchmarked to them, sovereign issuers corporate entities of sovereign issuers along with their respective market capitalisations. Im- Currency Denomination USD USD LC proving financial conditions in many emerging market

Average Rating (S&P) BBB- BBB BBB+ counties have resulted in ratings upgrades by the EMD issuers. All three of the major J. P. Morgan EMD indices now have an investment grade average rating. Benchmark characteristics

Countries 44 30 14 Hard currency vs. local currency

Asia (%) 19.4 39.9 29.0 As recently as the 1990s, most emerging market econo- mies did not have the ability to issue debt denominated Europe (%) 30.3 15.9 34.2 in local currencies, except at the shorter end of domestic (%) 39.6 29.0 26.8 yield curves. Middle East/Africa (%) 10.7 15.2 10.0 Countries had to go to the global markets with the sup- Yield 5.8 6.1 6.6 port of IMF to raise debt in U.S. dollars or euros. But Duration 7.0 6.3 4.6 the situation has changed rapidly in the last decade. With stronger fiscal conditions and better macroeconomic Source: J.P. Morgan EMBI December 2011 policy implementation, most of the sovereign entities in emerging economies do not raise hard debt anymore. In addition, many countries have loosened restrictions that previously prevented foreign ownership of local currency Figure 7. J.P.Morgan Emerging Market Bond Index market capitalisation debt. Thus, it is not surprising that local currency debt as of January 2, 2012 is the fastest-growing segment of the overall emerging market debt universe. J.P. Morgan EM Indices USD (bn) Top countries holdings in the Index Because of improving fiscal conditions in many emerg- Local Market Debt ing market countries, the outstanding issuance of exter- GBI-EM 485 Mexico, Poland, South Africa, Malaysia, Turkey nal (hard currency) emerging market sovereign debt has

GBI-EM Global 782 Brazil, Mexico, Poland, South Africa, Malaysia been on net decline. However, local currency debt has grown to hold the lion’s share of the EMD market, with GBI-EM Global Diversified 782 Brazil, Indonesia, Malaysia, Mexico, Poland, South Africa, Turkey the corporate component in hard currency growing at GBI-EM Broad 1383 China, Brazil, India, Mexico, Poland a rapid pace. There are also greater opportunity sets in External Debt both local currency bonds and corporate hard currency, EMBI Global Diversified 782 Brazil, Mexico, The Philippines, Russia, Indonesia as they still represent a small portion of the investable

EMBI Global 1383 Mexico, Russia, Brazil, Venezuela, Turkey universe (Figure 8).

Corporate External Debt Corporate EMD CEMBI Broad Diversified 209 Hong Kong, Brazil, Russia, Korea, Mexico Since 2003, emerging market corporate debt issuance CEMBI Broad 419 Brazil, Russia, Hong Kong, Mexico, Korea has been approximately twice that of sovereign debt issu- ance and EM corporate debt has rapidly developed into a Source: J.P. Morgan EMBI December 2011 significant asset class with primary issuance in the hard currency space (Figure 9). Apart from the high growth

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rates of their domestic economies, EM corporate bonds Figure 8. Emerging and developed economies have become a standalone asset class and have benefited as a percentage of world total, as of June 2011 from improved credit quality and declining default rates. Corporate bonds now constitute the majority of out- (US bn) Index Market Total AUM Benchmarked Ratio AUM / standing EM external debt. The liquidity of corporate Capitalisation against EM Indices Index EM debt, which was a critical issue for institutional in- Sovereign Hard 457 231 51% Currency vestors, has also improved in recent years. The issue sizes Corporate Hard 419 30 7% of corporate debt have also increased in the last few years. Currency

EM corporations’ balance sheets are fundamentally Local Currency 782 146 19% improving, and balance sheet strength was fully tested in Bonds 2008 and 2009. Many EM corporations are global-size Source: J.P. Morgan players who are among the world’s lowest-cost produc- ers. Leverage in both investment-grade and highyield EM corporate debt is materially lower than leverage in comparable developed market corporates. Figure 9. Emerging market corporate and sovereign debt insurances, USD bn (2000-2011) Exhibit 9/ Emerging market corporate and sovereign debt issuances, USD bn (2000–2011) Deeper and more diversified markets 250 Emerging markets have evolved over the last decade. The The quote asset class is now deeper and more diversified, with more 200 countries in the benchmarks. Market capitalisation of Emerging market n s 150 o i l l

the local EMD has surpassed the U.S. High Yield mar- b i debt has consistently $ ket capitalisation (Figure 10). Investors can also choose S 100 outperformed other U between external debt, local debt, sovereign and quasi- fixed income asset 50 sovereign debt, corporate debt, etc. There is a healthy classes over a long CDS market as well. In addition, the debt profile of the 0 period of time. 2000 2002 2004 2006 2008 2010 asset class now has a healthy percentage of investment- Sovereign Corporates and quasi-sovereign grade debt. While the investable universe has grown in Source: J.P. Morgan Source: J.P. Morgan recent years, the non-investable universe (non-index market), especially in China and India, has also grown rapidly. Figure 10.Market capitalisation, in USD bn A few years ago, the major appeal of emerging market (2003-2011) debt as an asset class hinged on its low correlation to other Exhibit 10/ Market capitalisation, in USD bn (2003–2011) 1,800 s

assets, which offered investors opportunities to leverage n

o 1,600 i l l i the potential diversification benefit in a well-constructed b

$ 1,400 S portfolio. As Figure 11 shows, however, more recently U n

i 1,200 , n o

the correlation of EMD with other asset classes has been i

t 1,000 a z i l

low to moderate. Yet EMD still provides diversification a

t 800 i p a benefits to a portfolio of short-term Treasuries. Returns c 600 t e k r in the recent past (post-2008) showed an increase in cor- a 400 M relation of external sovereign debt with equity markets 200 and U.S. High Yield indices. 0

J.P.Morgan Emerging Market Bond Index Global Returns enhancement J.P.Morgan Corporate Emerging Market Bond Index BroaSource:d J.P. Morgan, Barclays Capital J.P.Morgan Global Bond Index Emerging Market Broad Emerging market debt has consistently outperformed Barclays Capital US High Yield Source: J. P. Morgan, Barclays Capital other fixed income asset classes over a long period of time (Figure 12). Local market debt (J. P. Morgan tic pension plans and sovereign wealth funds, which have ELMI+) was an outperformer until 2003, as the market become an important source of demand for emerging was very thin and there was much skepticism about local market assets. currency money market debt; however, larger issuances On the supply side, the fundamentals of the issuers of local currency debt have since moderated the returns. have also significantly improved, reducing the need to Emerging external sovereign debt (J. P. Morgan EMBI issue additional external debt for a given issuer, local cur- GD) has been an outperformer since 2003. rency debt is usually expected to have higher yields than There are two possible explanations – demand has bonds denominated in hard currency. This arguably re- outstripped supply, and the fundamentals of the issu- flects the higher risk of holding emerging market cur- ers have significantly improved. On the demand side, as rency. However, very often the so-called “carry trade” emerging market countries improve their fiscal discipline (or “forward rate bias”), which describes higher-yielding and better manage their economic growth, they accumu- currencies’ empirical tendency to appreciate against low- late foreign currency reserves and build up their domes- er-yielding ones, can be observed in the emerging market

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Figure 11. Correlation of J. P. Morgan EMBI GD (external sovereign debt) with other asset classes

JP Morgan Barclays Capital Barclays Capital Barclays Capital MSCI Russell US Citigroup Emerging Markets U.S. Aggregate Corporate High Treasury-Long Emerging 1000® Consumer T-Bill 3 Bond Index Plus Bond Index Yield BB (Ba) Index Term Markets Index Price Index Month Index

1994-2011 0.98 0.36 0.56 0.17 0.66 0.54 0.00 0.01

2009-2011 0.99 0.31 0.75 -0.25 0.74 0.60 -0.07 0.38

Source: J.P.Morgan, BarclaysCapital, MSCI, RussellIndex, Citigroup

Considerations for emerging Figure 12. Cumulative returns (%) of various asset classes (1994-2011) market debt Exhibit 12/ Cumulative returns (%) of various asset classes (1994–2011) It appears that the emerging market debt asset class has, 700 as at this time, priced in better fundamentals, better debt servicing capabilities and the more prudent macro- 600 economic policies of emerging market economies. Some 500 EM trade at much narrower spreads than those of some U.S. states and municipalities, and of much of the 400 indebted peripheral Europe. 300 There are compelling reasons to consider adding EMD to a fixed income portfolio. The growing strength 200 of emerging market economies is also driving stocks’ gains, and that may change the appeal of EM debt in 100 the medium term. Potentially, the market may turn into 0 a lower-risk and lower-return fixed income asset class, much similar to credit-rated debt in developed markets. However, given the recent appreciation in the prices of J.P. Morgan Emerging Market Bond Index Global Diversified some of the emerging market debt instruments, it will J.P. Morgan Emerging Market Bond Index Plus Barclays U.S. Aggregate Bond Index Russell 1000® Index be imperative to be selective in this growing asset class. MSCI Emerging Markets Index Citigroup T-Bill 3 Month Based on improving macroeconomic fundamentals, emerging market debt may be an attractive asset class to complement both fixed income and equity assets. At present there is not much outstanding external sovereign space. High-yielding currencies’ tendency to strengthen debt in the market, and amounts are not increasing as or depreciate less than implied rate differentials rapidly as demand. EMD local currency debt might be makes holding local currency debt appealing. appropriate for investors who are looking for currency This is further corroborated by recent return charac- exposure and who have confidence in the currency ap- teristics; in the recent past, monthly returns of local cur- preciation story. fs rency instruments have been less volatile. Overall, local currency instruments have better risk/ SOURCES return profiles than hard currency debt, but the higher Jim Franks, Director, Investment Consulting, Australia: “Global high yield returns come from currency appreciation, which ex- bonds and emerging market debt.” Russell Research, April 2010. poses the portfolio to any currency crisis in emerging Joyce Chang: “Reassessing what we know about the emerging markets: a markets (as in the Asian financial crisis of 1997). Local review of key trends and risk.” J. P. Morgan, April 2011. currency instruments are thus suitable investment vehi- Cynthia Steer: “Developing local currency bond markets in emerging cles for those who want a greater exposure to currency economies.” A presentation to the Republic of Egypt and the , risk. However, it can be suitably argued that the curren- March 2010. cy appreciation is an aftereffect of the overall economic Mary Fjelstad, Steve Fox, Mark Paris and Michael Ruff: “The Role of strength of emerging markets. Emerging Market Debt and High Yield for a U.S. Investor.” Russell Research Commentary, May 2004.

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