Emerging Markets Fixed Income

A Manager Writes about the emerging markets fixed income

Paul McNamara, Julius Baer Investments, London

Emerging Markets Debt has come a long way from its slightly disreputable roots as the result of the “Brady Plan”, when the US Treasury (at the third time of asking) came up with a solution to the Third World Debt Crisis of the 1980s. The key to the solution was that the bankrupt nations rescheduled their debts into tradeable bonds, thus allowing the creditor nations to get the money off their books. When Russia’s default was the trigger for the financial market chaos that culminated in the meltdown of LTCM, the asset class’s reputation as a forum for cowboys rather than a serious capital market seemed sealed. When Patrick Beeley, Morgan Stanley’s veteran head of EM sales was asked for a fundamental justification of the asset class, his notorious verdict was “buy it, shagger, it’s going up”.

So why, now, have emerging markets muscled their way back into the front rank of financial markets? And why does it provide such a useful niche to hedge funds?

The answer to these questions can be derived from examining a “perfect market” for hedge funds. Such a market would: be volatile; offer a wide variety of instruments, traded by segregated groups of investors and at least one of these groups of investors would be prone to excesses of greed and fear; there would be limited transparency and asymmetric access to information; and the market would be liquid. These are the essential preconditions to create the sort of mispricings and, crucially, the ability to correct these mispricings, that hedge funds trade on.

Emerging market volatility is generated by these markets being the marginal producer in the global economy and the marginal consumer of capital over the economic cycle. When global industry booms, the last variable to react tends to be commodity prices – and as recent events have shown, this reaction tends to be violent. Similarly, when global liquidity is at its strongest, large capital flows tend to run into relatively small economies. The resulting boom and bust cycle has in the past been exacerbated by the historic incompetence or corruption of the economic authorities, or the poor advice of international bureaucrats.

However, there are signs that these tendencies have become less pronounced. The key was the seven-year period of turbulence, beginning with the 1994 devaluation of the Mexican peso (the Tequila crisis) and culminating in the default of Argentina on its sovereign debt. Having floating currencies allows emerging markets to become masters of their own domain. It is significant that the only major default came in Argentina – whose currency peg was institutionalised. Before this cycle currencies as varied as the Czech Koruna, the Philippine peso and the Brazilian Real were all pegged by domestic monetary authorities to the global majors. By 2004, very few pegs remain – and emerging markets have regained monetary sovereignty. These traumas constituted a test that the market as a whole took and passed:

  • There is life beyond devaluation. Mexico, most Central European and most Asian emerging markets now have local currency yield curves extending out for twenty years. Even chronic inflation victim Turkey attracted extraordinary interest in its first venture into longer-dated (three year) issuance. Running relative value trades between local and external markets is the exactly the sort of trade hedge funds are suited to – capital structure relative value for bond investors.
  • Credit markets can work properly without the discipline of bankruptcy law. Emphatically, yes. Argentina’s US$80bn sovereign default passed through the Credit Default derivatives market smoothly. More broadly, outcomes of debt restructurings have ranged from the completely orderly (Uruguay) to the antagonistic and prolonged (Argentina) – a further source of volatility and return. Analysis of default outcomes effectively becomes another source of returns.
  • A major default can be successfully addressed by the market without severe dislocation. Another question settled by the fact that neither Argentina nor Russia significantly dented either liquidity or interest in the asset class. Admittedly, the market at large was effectively granted a free put option by the Argentine authorities’ desperate use of the local pension funds as a buyer of last resort, but the forecast spillover effects never materialised. This was in itself a major step forward from 1998 in Russia, when there was widespread acrimony over the resolution of onshore counterparty risk in currency hedges.
  • The market has demonstrated the ability to evolve. Trading the original Brady debt involved a novel, but limited, skill set namely the ability to judge a sovereign credit risk path and the ability to price various embedded options and collateral. Now, however, a full EM toolbox includes the ability to deal with a burgeoning range of markets: deep and liquid FX (and FX options) markets, emerging corporate issuance, credit default swap markets and domestic interest rate markets.

At the same time as the market moves to increasingly specific and sophisticated strategies, the individual instruments are becoming simpler and more standardized. The debtors are retiring the complex Brady structures and replacing them with straight bonds. Local bonds increasingly settle offshore. The CDS market is sufficiently standardised that trades can be assigned between counterparties, ensuring a liquid, competitive market.

This proliferation of instruments allows investors to strip out various risks and target specific variables in a country. For example, can Turkey’s lavishly capitalized and profitable banks go bankrupt unless the sovereign does? Probably not – so investors buy corporate debt and default protection on the sovereign and pick up the premium. Or do Brazilian local interest rates of 16% really reflect local monetary conditions – or exaggerated risk premia? Apart from the usual elements – credit risk, interest rate risk, foreign exchange risk, Treasury risk with added volatility and yield – the asset class has some special new tradeable risks: convertibility risk (the prospect of not being able to repatriate investment proceeds), or convergence risk as well as more exotic risks such as oligarch risk (the financial consequences of a Russian or Ukrainian corporate running afoul of those countries’ presidents).

The market has got ever deeper as a variety of new entrants have entered various segments of the market. Even the Investment Consultants who advise institutional investors and pension funds on both sides of the Atlantic have now caught up with the value emerging external debt adds for a typical, diversified long-only investor. Most studies show that the asset class has a higher Sharpe ratio than High Yield debt. This diversification is becoming institutionalized as mainstream bond indices include emerging markets. The Lehman Global Aggregate index already includes Mexico and investors looking for a Russian upgrade to investment grade. On the local side too, yield-hungry European investors have owned bonds in the new member EU states for years. This year, US investors have been tempted South by the double-digit yields offered in Mexico.

The depth of these markets have allowed investors to lean to the arbitrage end of the relative-value spectrum running basis trades in credit markets (Credit Default Swaps vs cash bonds) or government bond markets (Interest Rate Swaps vs cash bonds).

If hedge funds are seen as being essentially in the business of exploiting and ultimately correcting anomalies, then we can point to several reasons why emerging markets are particularly persistent generators of such anomalies. Aside from volatility and lack of transparency, the segregated nature of the market helps create valuation anomalies. The largest set of holders of foreign currency debt is long-only real money. These investors tend to heavily favour sovereign issues and are forced to pay a premium to diversify, given that the key industry indices do not reflect the float of available debt. The swing investors in this asset class would tend to be crossover investors, who have a history of momentum driven buying of tops. Corporate issuers meanwhile have a much smaller investor base, and even quasi-sovereigns may have to pay up. Meanwhile, commercial banks and CDOs provide a steady bid for Credit Default protection. Why else (for example) would the City of Kiev have to provide a put option and 75bps of extra yield over and above Ukraine? Local markets on the other hand will tend to be largely owned by domestic investors, who will be risk averse (because of their inability to diversify) but also tend to provide liquidity in periods of extreme stress. Hedge funds will continue of course to enjoy the advantage of the wider range of instruments available.

Generalisations can be treacherous, but there are certain guiding principles that have served well in the past at least; that local markets react faster and more violently to events than external ones; the market at large attributes a very high premium to liquidity – perhaps reflecting a reliance on stop losses rather than hedges among long-only investors; sovereign risk is priced expensively to quasi-sovereign risk; the market is vulnerable to changes in global risk appetite and is never as vulnerable as when it is popular. Embedded options are often mispriced.

The market is certainly evolving, and can take one of two directions going forward. If recent progress is sustained, and global terms of trade continue to favour these commodity producers, emerging markets will lose much of their distinctiveness and converge with the emerged markets – tightly traded, keenly scrutinized with value reverting to areas such as conventional macroeconomics or corporate risk analysis. Even optimists would concede that such an outcome is several years off. Students of history would clearly see the alternative outcome as being at least as likely – hubris driven by recent successes causes local policy makers to trigger a new round of crises – with or without assistance from the Federal Reserve. Either way, the rich seam of financial opportunities in these markets is far from being exhausted.

Paul McNamara is a portfolio manager with Julius Baer Investments Limited in London and part of the successful investment team that has seen two single strategy fixed income – relative value and macro – hedge funds launched since January 2002. Julius Baer Investments Limited now has single strategy fixed income assets in excess of US$1.4 billion. Paul is Portfolio Manager for the Julius Baer Credit and Emerging Markets Hedge Fund which will be launching 1st November 2004 and is provisionally scheduled to take public subscriptions from 1st January 2005. Paul is an Emerging Market debt specialist and has 7 years experience at Julius Baer in London.