Bond opportunities are still emerging

IF YOU are on the hunt for strong and diversified returns from emerging markets, local currency denominated debt can give you solid exposure to attractive yields.

Until the 1990s, due to poor liquidity and low transparency, emerging market debt was issued only in hard currencies, predominantly the US dollar. But many emerging markets now run disciplined fiscal and monetary regimes, and have cast off policies that previously gave investors nightmares over the potential for currency devaluation, bond defaults and rampant inflation. At the same time, many emerging markets have liberalised their currencies, removing pegs to the US dollar, and allowing them to float freely. As recently as 1996, 70 per cent of all emerging market economies either pegged to the dollar or ran a US dollar economy. Now, with the notable exception of China, the majority of emerging markets’ currencies are either free floating or subject to minimal controls.

These reforms mean that the floating currencies are less exposed to global shocks in times of volatility. With the move away from the fixed currency regimes of the past, the correlation between emerging market debt and that of developed markets has been kept low, giving it the potential to form the core of a diversification strategy – helping to manage risk and achieve excess relative returns in changing market conditions.

And this debt issuance has seen quickly accelerating demand. According to Dealogic, domestic emerging market corporate bond volume has led the surge with $276.2bn (£171.8bn) in 2012, up 38 per cent compared to the $200.4bn raised in the same 2011 period – the highest year-on-year increase since 2009 (129 per cent). Total emerging market debt capital market volume also stands at a record $751.3bn so far this year, up 31 per cent from the $572.6bn raised in the year-to-date 2011. Corporate issuers account for 54 per cent of total emerging market volume, up from the 53 per cent share they held in the same period last year, and marking the highest proportion on record.

Local currency denominated debt is a very different beast to its emerging market dollar denominated equivalent. Though both are issued by the same country, they are a different asset class, with differing underlying risk considerations. Where the debt is dollar denominated, its yield spread is measured against US Treasuries and so is at the mercy of domestic US policy. However, local currency denominated debt is measured on currency and duration risk – driven by domestic monetary policy. And it is this currency risk that makes local currency emerging market debt a draw for those who want to diversify away from dollar and euro debt.

It is a mistake to lump emerging market economies into the same class. Even the Bric grouping of Brazil, Russia, India and China, coined by Goldman Sachs’s Jim O’Neill, contains greatly varying economies, and that is before you include smaller markets like Indonesia into the mix. Before taking a position on an emerging market issuance, whether at the corporate or sovereign level, you should consider external macro factors; the internal fundamental conditions such as political and economic risk; as well as market conditions dictating liquidity and leverage available.

With more than 60 per cent of emerging market debt now rated at investment grade (BBB- or above), emerging debt has gone a long way from its junk bond past. As the market grows, so will the opportunities to profit from emerging market development.