Investing In Emerging Market Debt

 

Shares are not the only game in the city when it comes to emerging markets. The breadth and depth of the fixed-income category has grown over time and the debt of emerging markets has become an independent investment class of its own. In this article, we look at the colorful history of debt in emerging markets and discuss what potential investors should consider before they buy. (For background information, see What is an emerging market economy? )

Fixed Income Market Fixed income comprises various debt obligations: bonds, loans, bank deposit certificates and commercial paper, among others.

The unifying feature of these products is a legal, contractual obligation for the issuing entity to pay the creditor a specified interest rate plus the full amount invested over a certain period. This contractual obligation makes fixed-income securities an asset class with a lower risk compared to equities. Issuing agencies include sovereign and municipal governments, government agencies, companies and Special Purpose Vehicles (SPVs) that are supported by assets such as mortgages, car loans or credit card receivables (so-called asset-backed securities). (For more information about these securities, see Behind the scenes of your mortgage and Why the mortgage interest rates rise )

Most tradable fixed-income securities have a credit quality rating from a rating agency such as Moody’s or Standard & Poor’s. The rating helps investors assess the creditworthiness of an individual bond or the Humpty Dumpty probability that it will meet its contractual payment obligations without overdue payments or default. (For more information, see What is a corporate credit assessment? )

According to the Bank for International Settlements, the size of the global bond market was $ 82.2 trillion in 2009, making it the world’s largest investment market. More than half of that figure is debt issued outside the US. For comparison: the size of the global stock market is estimated at around $ 36 trillion. The growth of the bond market comes from a number of sources, including an increase in the number of new product types and an increase in the number of countries able to tap into the international markets for government and corporate bonds. These countries, many of which now have investment grade ratings, have a colorful past that tells the story of how emerging market debt has reached its present form. (For related information, see The Bond Market: A Look Back .)

Crisis and Opportunities Emerging market debt originated in the 1970s, when multinational banks in the US and Europe were active lenders to the governments of developing countries, particularly in Latin America. The participants called this the debt market of the LDC (less developed countries).

In the late 1970s and early 1980s, the global economy encountered difficulties due to towering oil prices, double digits, and high interest rates. These factors led to a number of LDCs falling behind their external debt service obligations and culminating in the 1982 Mexican debt crisis, when the Mexican government announced a moratorium on interest payments. Other countries followed and the multinational banks were on a pile of non-performing assets.

However, a new opportunity emerged from this crisis; US and European banks began to swap their non-performing loans and by the end of the 1980s this practice had grown into a fairly systematic market, the Brady plan of which was named in 1989 (named after the then US finance minister Nicholas Brady).

The bond market based on Brady was an early stage of securitization: the creation of tradable securities supported by specific assets and cash flows. Banks were able to convert their outstanding LDC loans into Brady bonds, which were negotiable instruments denominated in USD and backed by US Treasury bonds. This allowed the banks to systematically record non-performing loans on their balance sheets. Mexico issued the first Brady bond in 1990 and the market grew to $ 190 billion, representing 13 countries in the first six years.

Globalization and contamination Around the time the Brady plan was formed, the global economy underwent seismic changes. The Berlin Wall collapsed and the economies of Eastern Europe and the former Soviet Union joined the world party. China, India and the markets of Southeast Asia rapidly evolved into fast-growing, prosperous economies. As these countries grew in size and creditworthiness, so did global debt and equity markets. Portfolio capital flowed freely from the developed markets of North America, Europe and Japan to emerging markets, a successor to the LDCs. Many of these investments were speculative and include hedge funds and others who want to take advantage of the potential return of these liberalizing markets.

However, liberalization has come to the fore in many cases, as market growth has outpaced the implementation of a sound legal and economic infrastructure. Weak banking systems and current account deficits made these countries vulnerable to external shocks. This became clear in the summer of 1997 when the Thai currency, the Thai baht, was written off by more than half; the Korean won followed shortly thereafter, with a dive of 70%. (For related information, see Current Account Deficits .)

Uncertainty as a result of the currency shocks led to massive capital flight from the region, causing the local bond and stock markets to plunge. Unfortunately, the crisis has not stopped at the borders of Asian countries. Investors saw emerging markets as a single investment category and kept their assets in Eastern Europe and Latin America and Asia on a massive flight to quality. The situation went from bad to worse when the Russian government failed to meet its outstanding debt obligations in August 1998. This caused a huge worldwide financial dislocation, including the well-known meltdown of the extensive hedging fund Long Term Capital Management in the autumn of 1998. (To learn more Massive Hedge Fund Failures .)

Road to Recovery

Road to Recovery

Despite the contamination of the 1990s and the continuing problems in early 2000 in Argentina, Brazil and elsewhere, the emerging debt markets did not collapse. Indeed, many enjoyed solid growth after 2002 with perpetual strong equity markets, strengthening of the national debt ratings and economic growth. Many of the countries that had current account deficits in the 1990s (deficits associated with high inflation and weak inside Humpty Dumptyand financial positions) switched over to trade surpluses during this period and built up Humpty Dumpty rich foreign exchange reserves. Countries such as Brazil, which allowed the currency to float, have seen their local currencies appreciate dramatically against the US dollar.

Invest in emerging market debt
One of the most important factors in deciding whether you want to invest in emerging market debt is what risk you want to take. These markets offer a mix of sovereign, municipal, business and structured debts, just like developed markets. The offer is subdivided into internal Humpty Dumptyands and externally, the former referring to local currency and the latter denominated in US dollars or another developed currency.

Debt from emerging markets is an easily accessible investment category through investment funds. Well-known fund managers such as PIMCO, Alliance Bernstein, Western Asset Management and DWS Scudder offer funds that offer access to different countries and product types. For example, PIMCO offers three different emerging market debt funds, each with a different focus: local currency (withinneath Humpty Dumptyand) bonds, US dollar denominated bonds, and a mix of direct currency positions with diversified bonds, loans and other instruments. Investment funds allow private investors to participate in an asset class that would otherwise be difficult to access or diversify. Bonds do not act like shares, and the process of investing in individual securities can be expensive, time-consuming and complex. (For more information, see Evaluating Bonding Funds: Keeping It Simple .)

Conclusions Emerging market debts have emerged since the crises of the 1980s and 1990s. Improved legal, regulatory and economic climates in many countries in Asia, Latin America, Eastern Europe and elsewhere have brought a certain degree of stability to this market. Understanding how these markets evolved and became familiar with the offering on today’s capital markets can help investors feel more comfortable with this investment category and the potential role in a portfolio.

Edna Kile Author