Investors have been pouring into emerging market funds to obtain exposure to the superior growth prospects of less developed markets.
While emerging market (EM) stock funds were the hot story last year, EM bond funds are now the big attraction, and are seen as a less volatile home than equities but offering the attractive yields and rapid growth missing in the developed world. Year to date, through to September 1, EM bond funds have taken in $34bn (€26.7bn) of net inflows according to data from EPFR Global. The previous record inflow for an entire year was in 2005, when they took in $9.7bn.
Investors have also taken comfort from the more disciplined management of government finances and monetary policies focused on inflation targets, which have helped reduce the volatility of bond market returns across Asia.
Sound fundamentals
The exponential growth in the take up of EM bonds is largely institutional investors such as pension funds diversifying into the asset class for the first time, which can mean single allocations of as much as $100m. Fund managers report they are taking a lot of reverse enquiries.
At Pictet, for example, EM fixed interest under management has trebled to $14.4bn, from $4.5bn-$5bn last December.
“Emerging markets have provided substantial opportunities over the past decade in terms of returns on the back of steady improvements in fundamentals,” says Matt Ryan, vice president of MFS Investment Management. “Flows into emerging market fixed income have been steady and large as investors navigate between equities, which are still perceived as too risky, and risk-free rates, which offer negligible returns,” he explains.
“In general, credit markets – including emerging market debt – have offered a middle ground in a global economy that is muddling along. When investors examine the risk-adjusted returns of the asset class and the solid fundamentals underpinning its multi-year outperformance, one can increasingly look at emerging market debt as an alpha story rather than beta story – one that can outperform in both bull and bear markets,” adds Mr Ryan.
Each country presents a completely different set of risks, however, even among the more developed nations such as South Korea, Malaysia and Brazil, where mutual funds concentrate their efforts. Fund managers generally avoid less stable regions such as Venezuela, Ecuador or Iraq. Currently, emerging Europe has joined those out of favour as GDP growth is weak and debt positions are causing concern.
One approach is to choose growing economies, but ones where central banks will not raise rates by as much as the market predicts.
“Our general strategy is to look for a solid and stable credit and markets where there is a belief that the recovery is robust and that central banks will have to follow a tightening policy, but where we think that is wrong, where we actually think the central bank won’t have to tighten as much as the market expects because the global recovery is more tepid than the market thinks,” says Michael Gomez, executive vice president at Pimco.
“In Latin America, we think Brazil is a unique and attractive story. It has experienced sharp growth and so some investors fear a higher core inflation rate and the market has interpreted a larger tightening cycle, but in reality the recovery is more tepid and deflation forces are in evidence in the developed world,” he says.
Mr Gomez explains that while nominal rates for Brazilian bonds are around 11.5 per cent, real rates are some of the highest in the world. “This is probably a result of Brazil’s history of inflationary shocks, so the local population is quite guarded and demands a significant premium,” he explains.
“The consumer price index is currently 4.6 per cent against the Central Bank’s mandate to keep it at 4.5+/- 1.5 per cent, and the Central Bank has a reputation as credible and hawkish. Mexico is a similar story.”
Searching for alpha
So large are the inflows into this asset class that they have even begun to constrain opportunities for managers to outperform, according to MFS’ Mr Ryan. “Managers are really branching out and looking to add alpha with local currency and corporate bonds and we are seeing a lot more issuance in those areas to accommodate that need for more attractive risk reward opportunities,” he says.
Most EM bonds were traditionally sovereign, but corporate bond issuance is growing as businesses look for new sources of funding and as foreign investors become more comfortable with improvements in corporate governance, transparency and local legal systems.
Low nominal rates and favourable inflation trends have also allowed the corporate market to spring to life. In Turkey for example, double digit nominal rates were prohibitive for years but rates are now down to 8 per cent.
