An Asset Class in Its Own Right. The Case for a Strategic Allocation to Emerging Markets Debt. Investment Focus

Transcription

1 Investment Focus An Asset Class in Its Own Right The Case for a Strategic Allocation to Emerging Markets Debt Less than a decade ago, debt issued by emerging-market countries was not considered a meaningful investment option for global investors. In most cases, any emerging-market debt regarded as suitable for investment was issued in hard currencies, such as the US dollar, and local-currency debt was granted even less prominence in global portfolios. Generally, any allocations to emerging-market debt were part of broader fixed-income strategies. Back then, emerging-market nations that issued hard-currency debt entered into a substantial foreign currency liability mismatch, which in some cases led to bankruptcies and crises. Over the past decade, the Lazard Emerging Markets Debt team has witnessed the increase in breadth as well as depth of this asset class worthy of consideration in its own right for many investors portfolios.

2 2 Introduction Over the last decade, emerging markets (EM) have, for the most part, evolved from unstable, volatile countries to become solid economies. Today, many EM countries benefit from strong macroeconomic fundamentals relative to their developed-market counterparts. More importantly, emerging economies now represent an increasing portion of global GDP, and their growth rates continue to outpace those of developed markets. As such, the term emerging may no longer be an accurate description for some countries currently grouped in this universe. In this paper, we examine how this macroeconomic backdrop, among other factors, has helped develop the investment opportunity set in the emerging markets, particularly in emerging markets fixed income (interchangeably called emerging markets debt, or EMD). While some countries in the emerging world remain susceptible to economic and political turbulence, over the last several years the vast majority of EM countries have established stronger political institutions and implemented sound economic policies. Central banks are now independent and credible, which helps achieve much lower inflation. In addition, significant fiscal adjustments have led to a speedy reduction of public debt burdens. From an external debt perspective, sizable foreign direct-investment inflows have contributed to more stable sources of current-account financing. In addition, creditor-friendly laws have laid the foundation for larger, more mature EMD markets.¹ How Big Is the EMD Market? As the EMD asset class has developed, it has become a compelling component of global portfolios. Fundamentally, the EMD market is divided into two principal categories: 1) external or hard-currency debt, which is issued in a currency other than that of the issuer s domestic currency and 2) local-currency debt, which is denominated in the domestic currency of the issuer. Historically, local debt markets were under-developed, and as a result, emerging countries primarily issued hard-currency debt, mostly in US dollars. In some cases, this practice contributed to foreign exchange and debt crises as exchange rate fluctuations caused liabilities in hard currencies to balloon. Some examples of this include Mexico and Thailand in the 199s and Argentina in the early 2s. However, as macroeconomic fundamentals improved in EM countries, local currency markets have also deepened, reducing dependence on external debt and avoiding its associated risks. One area that continues to grow is corporate debt, which can be a compelling source of value (more on this later). The total outstanding debt in emerging markets has risen to approximately $14 trillion based on the data from the Bank of International Settlements (BIS),² mostly due to the expansion of the local-currency market (Exhibit 1). In comparison, the market capitalization of the Barclays Capital Global Aggregate Bond Index a proxy for the global investment-grade bond market was approximately $45 trillion as of June 214. This evidences that the size of the asset class is now significant. Data by issuing sector (government, financial institutions, and corporates) show that the percentage of total local-currency debt for each sector has remained relatively static over the past decade. However, for hard-currency debt the percentage of government issuance has significantly declined (Exhibit 2). This suggests that as local-currency debt markets continue to develop, sovereigns are shifting away from issuing hard-currency debt thereby reducing future foreign exchange risks. In addition, when combining the local- and hard-currency debt universes, the non-governmental sector (i.e., financial institutions and corporates) accounts for roughly 52% of the total debt outstanding, signaling growing issuance and a deep opportunity set beyond sovereign debt. In fact, hard currency corporate issuance recorded a market capitalization of more than $1.5 trillion at the beginning of 214. This is $3 million larger than the US high yield universe.³ Thus far, we have examined EMD in aggregate, but it is important to note that the countries within the universe are considerably diverse. From a regional perspective, Asia holds the dominant position in local-currency debt, whereas the share of hard-currency debt is divided Exhibit 1 Emerging Markets Debt Has Reached Meaningful Volume Exhibit 2 Composition of Emerging Markets Debt by Sector ($B) 15, 1, International (External) Domestic (Local) (%) Local Debt External Debt , Government 213 Financial Institutions Corporates For the period December 23 to December 213 Source: BIS, Haver Analytics As of December 213 Source: BIS, Haver Analytics

3 3 Exhibit 3 Asia Has the Lion s Share of Local Debt while External Debt Is More Evenly Distributed Local Debt a External Debt b a As of December 213 b As of March 214 Exhibit 4 Top Ten Countries, Local and External Debt ($B) 5, 4, 3, 2, Source: BIS, Haver Analytics 33 Local Debt a Africa and Middle East Asia Europe Latin America more evenly, with Latin America and Europe slightly leading its peers as shown in Exhibit 3. When analyzing on an individual country level, as shown in Exhibit 4. Several Asian countries are ranked in the top ten domestic debt issuers, while the top ten external debt issuers are more balanced. It is also important to note that the inflation-linked bond universe has also grown significantly, reaching $618 billion in June 214. Given that the inflation environment in EM countries is generally more volatile than those in developed markets, we believe inflation-linked bonds offer a compelling option. In terms of regions, Latin America commands the greatest share of these securities, representing 78% of the total. 4 Although EMD markets have grown by an impressive amount and reached a considerable size, this does not directly correspond to the size of the actually tradable market, given that many EM assets have restricted access, low liquidity, or are subject to regulatory controls. Foreign exchange is also an important factor for international investors, and the EM universe encompasses a wide range of currency policies, from countries that have a free-floating and convertible currency to those whose currency markets are subject to strict controls. In addition, regulatory constraints for international investors may also limit access to capital markets in some countries. We believe the total size of the tradable market matters most for overseas investors and at year-end 211 this market reached an estimated $2.5 trillion and stands at nearly $3. trillion midway through As such, investors should closely follow policy developments that could improve access to these assets, in our view, as the future supply of EMD assets relates to the growth of the tradable market. EMD Displays Renewed Liquidity Trading volume for locally traded debt (independent of the currency of issue, for example this category would include US dollar and ian real debt traded within ), as well as hard currency sovereign and corporate debt has recovered from the lows of 29 at the epicenter of the financial crisis (Exhibit 5). The strong recovery in overall trading volume since the crisis demonstrates the 1, China ($B) 4 South Korea India MexicoMalaysiaTaiwan RussiaThailandTurkey External Debt b Exhibit 5 Trading Volume Has Recovered from the Financial Crisis Lows ($B) China Russia South Mexico Korea a As of December 213 b As of March 214 Source: BIS, Haver Analytics UAE Turkey Poland India Indonesia HC Corporates Locals HC Sovereigns As of March 214 Source: Emerging Markets Trade Association (EMTA), ING

4 4 resilience of EMD markets, as their liquidity bounced back after the crisis. This rebound further illustrates the meaningful degree to which EMD markets have developed in the context of global capital markets. With respect to individual countries, it is rare to Exhibit 6 Top Ten Countries by Trading Volume within Different Types of Debt Hard Currency Sovereign Trading Volume ($M) Russia Turkey Mexico Argentina Poland Venezuela Hungary Ukraine Indonesia Hard Currency Corporates Trading Volume ($M) Russia Mexico China Hong Kong Venezuela South Korea India see the same country leading in trading volume across different debt categories, as we evaluated the full-year trading data for 213 (Exhibit 6). In our opinion, this also reflects the local factors that drive investor demand and trading activity for different EMD sectors. As previously pointed out, the country universe is diverse with varying degrees of development and accessibility in their respective capital markets. Measuring Investor Demand The EMD investor base has experienced meaningful growth. For example, total assets benchmarked to J.P. Morgan EM fixed-income indices (including local, external, corporate, and local money-market debt) rose from approximately $38 billion in December of 21 to $622 billion in July 214. While this sum is dominated by external debt, assets benchmarked to corporate and local-currency indices have displayed the greatest growth over the last three years. 6 Another measure of investor demand is mutual fund flows. Despite the sell-off experienced in the asset class in the spring and summer of 213, the annualized five-year growth rate for cumulative flows is close to 6% (Exhibit 7). These data are most likely reflective of retail investors, whereas institutional flows were more resilient in light of the outflows. Although EMD markets have expanded over the past decade, allocation to this asset class by large institutional investors, such as pensions and insurance funds, has not kept up and is still small as a percentage of total assets. Estimates from recent pension fund surveys in the United States, the United Kingdom, and continental Europe indicate that on average only 3.2% of portfolio assets are allocated to emerging-market bonds. 7 This is a potential opportunity for further growth in the asset class and also appears to be an incentive for EMD markets to develop improved access and operations, as global institutional investors seek more exposure to these investments. UAE Turkey Local Currency Trading Volume ($M) Mexico India Russia Turkey Poland South Africa Singapore Malaysia Exhibit 7 Flows into EMD Mutual Funds Have Grown Significantly Cumulative Fund Flows ($B) South Korea For the year ended December 213 Source: EMTA As of 3 June 214 Data are based on Morningstar s Emerging Markets Bond mutual fund category. Source: Strategic Insight

5 5 Fundamentals and Quality of EMD Deepening of capital markets as well as a higher degree of economic development in emerging nations is evidenced by several metrics. As it relates to EMD, a uniformly upward increase in average credit quality since the late 199s has led to significantly lower sovereign spreads for hard currency debt (Exhibit 8). Despite a spike in sovereign spreads during the financial crisis, spreads have remained relatively stable since then and less susceptible to contagion from exogenous (i.e., non-em) events. In our view, this signals more robust debt markets in emerging countries overall. In the case of local currency debt, the average maturity of issuance has doubled since 2, which is another indicator of more seasoned markets. This has an important implication for many institutional asset allocators, as longer duration instruments allow them to consider EMD in asset liability matching programs. This assertion is further supported by the growing share of foreign ownership of local currency government bonds. For example, foreign ownership of government bonds in countries like Mexico and Malaysia was in the low single digits in 26, whereas in 214 it is 37% and 45% respectively. 8 As we stated earlier EM corporates can be a compelling source of value. Relative to US corporate bonds, those in emerging markets currently offer a yield advantage of roughly 1 basis points (bps) in investment-grade debt. Non-investment grade bond yield spreads favor EM issuers as well. At the same time, these higher yielding EM corporates exhibit better balance sheets versus their US peers: EM corporates leverage levels are about 1.3 times lower than US high yield bonds. 9 Performance Characteristics of EMD Historically, EM assets have been perceived as volatile investments, so we believe it is worthwhile to review their performance history both on an absolute and risk-adjusted basis (Exhibit 9). We measured the performance of hard currency, local currency, and corporate emerging-market debt as measured by the J.P. Morgan Emerging Markets Bond Index (EMBI), the J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM), and the J.P Morgan Corporate Emerging Markets Bond Index (CEMBI), respectively. The starting point for this analysis (December 22) was selected as the oldest date available to include all EMD indices. We found that hard and local sovereign emerging markets debt outpaced both US investment-grade fixed income and developed-markets equity for the period we evaluated. At the same time, EM equities outperformed all other assets in our sample, however on a risk-adjusted basis, the results for all three subsets of EMD are more compelling. Notably, the events of 213 caused EMD to fall sharply but since the start of 214 the rebound has been strong. From a portfolio construction context, emerging-market debt offers some diversification benefits based on statistical correlation that should not be confused for the type of diversification associated with traditional fixed income assets. Rather, the correlation (relative to equities) and volatility of EMD indices more closely resembles that of US high-yield bonds (Exhibit 1). The currency denomination of EMD is also important to consider when evaluating diversification benefits for a portfolio. The hard currency interest rate component of external debt may be able to offset some of the fluctuation in these risk assets, as shown by the lower volatility of the EMBI. Local-currency debt, however, is dependent on foreign-exchange movements as well as local interest rates leading to higher correlation than external debt in relation to other risk assets. Exhibit 8 History of Emerging-Market Sovereign Spreads (bps) 16 Asian Financial Crisis Russian Default LTCM Blowup Mexico Upgraded to Investment Grade Argentina Default Election Turmoil Russia Upgrade to Investment Grade Local Debt Issuance Surpasses External Debt Issuance Upgraded to Investment Grade Global Financial Crisis Sovereign Spread represented by stripped spread of J.P. Morgan EMBI Index [LHS] Trendline of average credit rating of the J.P. Morgan EMBI Index [RHS] US Downgraded Fed Taper Comments As of 31 July 214 Source: J.P. Morgan Greek Debt Crisis BBB BB+ BB BBB- BB-

6 6 Exhibit 9 Performance Cumulative Performance, December 22 = MSCI Emerging Markets Index J.P. Morgan EMBI J.P. Morgan CEMBI Barclays Capital US Corporate High Yield Index MSCI World Index Barclays Capital US Aggregate Bond Index J.P. Morgan GBI-EM Composite J.P. Morgan EMBI J.P. Morgan GBI-EM Composite J.P. Morgan CEMBI Barclays Capital US Aggregate Bond Index Barclays Capital US Corporate High Yield Index MSCI World Index MSCI Emerging Markets Index Sharpe Ratio Ann Return Ann Std Dev For the period December 22 to June 214 The performance quoted represents past performance. Past performance is not a reliable indicator of future results. The indices shown above are unmanaged and have no fees. One cannot invest directly in an index. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. Source: Barclays, J.P. Morgan, MSCI, FactSet Exhibit 1 Correlation J.P. Morgan EMBI J.P. Morgan GBI-EM Composite J.P. Morgan CEMBI Barclays Capital US Aggregate Bond Index Barclays Capital US Corporate High Yield Index MSCI World Index MSCI Emerging Markets Index J.P. Morgan EMBI 1. J.P. Morgan GBI-EM Composite J.P. Morgan CEMBI Barclays Capital US Aggregate Bond Index Barclays Capital US Corporate High Yield Index MSCI World Index MSCI Emerging Markets Index For the period December 22 to June 214 The performance quoted represents past performance. Past performance is not a reliable indicator of future results. The indices shown above are unmanaged and have no fees. One cannot invest directly in an index. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. Source: Barclays, J.P. Morgan, MSCI, FactSet

7 7 Conclusion In the past, EMD had not been considered as a meaningful asset class for global investors. However, over time the fundamentals of emerging economies have evolved and strengthened, which has contributed to the deepening of EM capital markets. In the last decade, EMD as an asset class has matured as EM countries increasingly facilitate access for foreign investors and as the debt market continues to grow. Specifically, local currency debt currently surpasses the size of external debt as many sovereigns can access their own deeper domestic markets for funding, thus avoiding exposure to exchange rate risk. In addition, as market-wide volatility from the financial crisis subsided, EMD liquidity (as measured by trading volume) has rebounded, suggesting that investors re-entered these markets. This might not have been possible without the added depth to EM capital markets and the strides in improved fundamentals made in EM countries over the past ten years. Investor appetite for EMD assets has not only increased significantly in the past decade, but has accelerated over the past five years, as demonstrated by mutual fund flows. The Lazard Emerging Markets Debt team provides investors access to the full spectrum of the EMD asset class. Our strategies are founded on the belief that within this burgeoning asset class there are broad structural sources of inefficiency and long-term cyclical trends in emerging markets that create a wide range of alpha opportunities to exploit. As returns can be divergent between countries and/or debt types, our experience has taught us that in-depth fundamental analysis and a holistic approach helps to improve returns for portfolios investing in a single category of emerging markets debt (e.g., focused only on hard currency debt). We also recognize that through various market environments there may be differing drivers of return: in certain market environments asset allocation (hard currency versus local currency debt or corporate debt) may have larger ramifications than country weightings. As a result, the team also offers blended portfolios (i.e., those able to allocate to hard currency, local currency, and corporate debt). In our view, the EMD opportunity set and global investor interest in the asset class are only just beginning to develop. Despite growing demand, the average allocation to EMD by large institutional investors based in developed markets remains low. Increases in portfolio allocations from global investors should result in an increase in demand that will likely have a positive impact on asset prices. As the investment opportunity continues to develop, we believe an active management approach is well-suited to capture the value in the EMD asset class. About the Lazard Emerging Markets Debt Team The Lazard Emerging Markets Debt team employs a flexible management approach that seeks to add value through different market environments. As active managers, they believe that bottom-up, security-specific analysis, in concert with a focus on fundamental global market trends, enables them to capitalize on the opportunities presented by inefficient markets. They offer five emerging markets debt strategies capitalizing on the opportunities at different stages of economic and interest rate cycles, providing the potential for attractive returns. The team was established at Lazard in 21, comprising members of a wellknown emerging markets debt team who to date have worked together for over ten years, with twenty-one years of industry experience on average. The team has adhered to a consistent philosophy throughout its history.

8 8 Notes 1 Burger, John, et al. Emerging Local Currency Bond Markets. Financial Analysts Journal, July/August Based on Securities Statistics Tables (International and Domestic Debt Securities), as of December 213. Includes countries under the Developing Countries category only, excludes Offshore Centers, Developed Countries, and International Organizations. Please note this information is included as it pertains to Exhibits J.P. Morgan Corporate Reference Presentation, March Source: J.P. Morgan Securities, as of June Source: Morgan Stanley, as of June Source: J.P. Morgan Securities, as of July Source: Morgan Stanley, as of January Source: J.P. Morgan, as of 3 June Source: J.P. Morgan, Bank of America Merrill Lynch, Lazard, as of 3 June 214. Important Information Originally published on 27 February 213. Updated and republished on 3 October 214. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the date of this publication and are subject to change. An investment in emerging-market debt positions are subject to the general risks associated with fixed income investing, such as interest rate risk and credit risk, as well as the risks associated with emerging-market investments, including currency fluctuation, devaluation, and confiscatory taxation. Investments in global currencies are subject to the general risks associated with fixed income investing, such as interest rate risk, as well as the risks associated with non-domestic investments, which include, but are not limited to, currency fluctuation, devaluation, and confiscatory taxation. Furthermore, certain investment techniques required to access certain emerging-market currencies, such as swaps, forwards, structured notes, and loans of portfolio securities, involve risk that the counterparty to such instruments or transactions will become insolvent or otherwise default on its obligation to perform as agreed. In the event of such default, an investor may have limited recourse against the counterparty and may experience delays in recovery or loss. Investments denominated in currencies other than US dollars involve certain considerations not typically associated with investments in US issuers or securities denominated or traded in US dollars. There may be less publicly available information about issuers in non-us countries that may not be subject to uniform accounting, auditing, and financial reporting standards and other disclosure requirements comparable to those applicable to US issuers. All index data is shown for illustrative purposes only and is not intended to reflect the performance of any product or strategy managed by Lazard. The securities and/or information referenced should not be considered a recommendation or solicitation to purchase or sell these securities. It should not be assumed that any of the referenced securities were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. Certain information included herein is derived by Lazard in part from an MSCI index or indices (the Index Data ). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom. The MSCI Index Data may not be further redistributed or used as a basis for other indices or any securities or financial products. Past performance is not a reliable indicator of future results. This material is for informational purposes only. It is not intended to, and does not constitute financial advice, fund management services, an offer of financial products or to enter into any contract or investment agreement in respect of any product offered by Lazard Asset Management and shall not be considered as an offer or solicitation with respect to any product, security, or service in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or unauthorized or otherwise restricted or prohibited. Australia: FOR WHOLESALE INVESTORS ONLY. Issued by Lazard Asset Management Pacific Co., ABN , AFS License , Level 39 Gateway, 1 Macquarie Place, Sydney NSW 2. Dubai: Issued and approved by Lazard Gulf Limited, Gate Village 1, Level 2, Dubai International Financial Centre, PO Box 56644, Dubai, United Arab Emirates. Registered in Dubai International Financial Centre 467. Authorised and regulated by the Dubai Financial Services Authority to deal with Professional Clients only. Germany: Issued by Lazard Asset Management (Deutschland) GmbH, Neue Mainzer Strasse 75, D-6311 Frankfurt am Main. Japan: Issued by Lazard Japan Asset Management K.K., ATT Annex 7th Floor, Akasaka, Minato-ku, Tokyo Korea: Issued by Lazard Korea Asset Management Co. Ltd., 1F Seoul Finance Center, 136 Sejong-daero, Jung-gu, Seoul, United Kingdom: FOR PROFESSIONAL INVESTORS ONLY. Issued by Lazard Asset Management Ltd., 5 Stratton Street, London W1J 8LL. Registered in England Number Authorised and regulated by the Financial Conduct Authority (FCA). Singapore: Issued by Lazard Asset Management (Singapore) Pte. Ltd., 1 Raffles Place, #15-2 One Raffles Place Tower 1, Singapore Company Registration Number W. This document is for institutional investors or accredited investors as defined under the Securities and Futures Act, Chapter 289 of Singapore and may not be distributed to any other person. United States: Issued by Lazard Asset Management LLC, 3 Rockefeller Plaza, New York, NY LR22746