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 emerging market debt, 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 EMERGING MARKET DEBT 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 loan years, the market debt appealing as a long-term strategic asset class. borrowings stayed on banks’ 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. bank loans 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 Bond 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. THE JOURNAL OF SUPERANNUATION MANAGEMENT• FS Super www.fssuper.com.au 31 Volume 04 Issue 03 | 2012 Investment 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 nJtagunee 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 Argentina, Brazil, Bulgaria, the Côte d’Ivoire, Costa Rica, Croatia, the Dominican Re- public, Ecuador, Jordan, Morocco, Nicaragua, Nigeria, Panama, Peru, the Philippines, Poland, Russia, Slove- nia, Uruguay, Venezuela 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 default 75 in mid-1998.2 Confidence returned to the asset class 50 shortly after, as Mexico’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 Colombia, 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 FS Super THE JOURNAL OF SUPERANNUATION MANAGEMENT• 32 www.fssuper.com.au Investment Volume 04 Issue 03 | 2012 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.