Risk rewarded

Despite the specter of an Argentinean default, emerging-markets debt delivers surprisingly strong returns.

Despite the specter of an Argentinean default, emerging-markets debt delivers surprisingly strong returns.

By Andrew Capon
December 2001
Institutional Investor Magazine

With Argentina poised on the brink of default, the value of its debt had plummeted 36 percent in 2001 through the end of October. Because the country accounts for a hefty 16 percent of the J.P. Morgan emerging-markets bond index plus, and because the risk of contagion constantly hovers over this sector, institutional investors that want exposure to emerging markets usually prefer equity to debt.

But that sentiment flies in the face of some striking facts. This year through the end of October, emerging-markets stocks fell 20.4 percent, while their debt counterparts slipped just 0.5 percent - despite the Argentinean debacle. Nor is the gap a one-time phenomenon. For the ten years ended October 31, the all-equity MSCI emerging-markets free index gained just 1.1 percent, versus a 13 percent annual return for the EMBI+, a basket of sovereign and quasi-sovereign (that is, backed by a state guarantee) debt issued in an external currency, usually dollars. Even over the past five years, a period that includes a number of major crises, debt has outperformed, returning 10.5 percent a year, versus a total decline of 67 percent for equity over the same period.

Some funds are beating the averages by a hefty margin. Over five years the Consulta Emerging Markets Debt Fund, run by London-based boutique Montpelier Asset Management, has posted 16.5 percent annualized returns and year-to-date is up 15.7 percent. Emerging-markets debt funds run by U.S.-based bond giant Pacific Investment Management Co. are up 17.6 percent this year.

Proponents of emerging-markets debt argue that fears of contagion are overstated; they also believe that the sector offers low correlation to other asset classes. Skeptics recall past crises - the Mexican peso crisis of 1994-'95, the Asian financial flu of 1997, the 1998 collapse of the Russian ruble - and conclude that new debacles, in Argentina or elsewhere, are almost guaranteed. Contagion, they say, is a credible, constant threat.

Says Thomas Cooper, a partner with Boston-based Grantham, Mayo, van Otterloo & Co., who oversees the firm’s $1.25 billion in emerging-markets debt: “Contagion [following debt restructuring in Argentina] won’t be as bad as in 1995 and 1998, but it’s still bad news for the markets and other Latin American credits, and even some in Eastern Europe could be hit. Once there is trouble, markets move together.”

Certainly, emerging-markets debt barely registers a blip on the radar screen of institutional investors that buy emerging-markets equity. Even today, as pension funds in the U.S. and U.K. nurse losses on domestic equity portfolios and search for high-return, low-correlation asset classes, emerging-markets debt struggles to find a place in institutional portfolios. (The correlation of the J.P. Morgan EMBI+ with the MSCI Europe, Australasia and Far East index over ten years is -37 percent.)

Bob Collie, director of investment consulting at consulting firm Frank Russell Co. in London, reports that his firm does not consider emerging-markets debt to be a mainstream investment opportunity. “I would describe it as an exotic asset class for a small number of sophisticated pension funds,” he says.

But when an emerging-markets crisis hits, argue the advocates of emerging-markets debt, it is much better to be a bondholder than a stockholder.

“The risks of holding equity and bonds are asymmetric in emerging markets,” says Mohamed El-Erian, head of emerging-markets bond investment at Pimco. “A crisis usually takes the form of a balance of payments problem. The remedy is to increase interest rates and tax more or spend less. That makes the public sector very strong but impoverishes corporates.”

Lincoln Rathnam, who launched the Scudder, Stevens & Clark Sovereign High Yield Investment Co. back in 1989 - the first mutual fund to invest in Latin American debt - heartily agrees. Says Rathnam, who now works as head of emerging-markets investment strategy at Vistech Corp., a private equity firm headquartered in Westport, Connecticut, “Back in 1989, I was telling anyone who would listen that bonds were a better bet than stocks because they are contractual obligations issued by governments.” They still are a better bet, Rathnam believes.

There are some technical explanations for the gap between the returns of emerging-markets debt and equity. The universes of countries included in emerging-markets equity and debt indexes, though overlapping, are significantly different. Emerging-markets equity indexes are skewed toward Asia and debt indexes toward Latin America. Debt indexes also include countries such as Bulgaria, Ecuador, Morocco, Nigeria, Panama and Qatar, where equity markets are small or nonexistent.

Yet even where equity markets do exist, debt still tends to outperform. The Russian stock market, for example, is up 15.8 percent in dollars, but the Russian bonds in the EMBI+ are up 36.9 percent in dollars through October.

As a group, debt investors also enjoy more liquidity than their equity counterparts. Says Philip Poole, head of emerging-markets research at ING Barings: “Investors have been prepared to pay a premium for liquidity. Since the Russian default liquidity in equity markets has been reduced sharply. That hasn’t been true for debt markets.”

Adds Jerome Booth, head of research at Ashmore Investment Management, a London-based emerging-markets debt specialist, “We can deal in $20 million tickets at a half [percentage] point [bid-offer] spread and substantially change our $1 billion portfolios in an afternoon.”

Predictably, fund managers that have avoided Argentina have done better than their peers. “We have been out for two years. Argentina’s problems have been so well telegraphed that anyone holding the debt deserves the haircut,” says Montpelier founder and chief Nick Cournoyer.

Surely, the Argentinean debt restructuring will test the maturity of the market. So far the contagion effects from Argentina have been modest. If they remain in abeyance, the asset class as a whole will be strengthened.

Most fund managers express confidence that emerging-markets debt will pass this test. Several structural changes should limit contagion, they say. To begin with, most countries now have floating-exchange-rate regimes. In past crises speculative money moved from one fixed currency to the next, roiling global debt markets.

Owners of emerging-markets debt cite the bullish effect of the recent shift in the sector’s investor base. Hedge funds, eyeing easy profits, had been big players in emerging debt in the late 1990s. Carry trades - for example, borrowing yen cheaply to buy high-yielding debt assets such as Russian local currency GKOs - were one common feature of the market.

Often these positions were leveraged. When Russian debt prices fell, these funds forced sellers to meet margin calls, exacerbating the downward price movement. When Russia eventually defaulted on its local currency debt obligations, many of these hedge funds went out of business.

Matthew Ryan, portfolio manager at MFS Investment Management in Boston, which oversees $500 million in emerging-markets debt, says that most of these players have not returned to the scene. “Argentina has been such an obvious problem that to the extent that hedge funds may be involved, they are short. Russia caught a lot of people off guard, and the result was carnage. If those funds are still in business, they have learned their lesson.”

Advocates of emerging-markets debt point out that the central goal of the International Monetary Fund - to fight balance-of-payments crises - has not changed, nor have its policy prescriptions of higher interest rates, lower spending and higher taxes. This will continue to be a dangerous cocktail for equities and a tonic for bonds.

And despite the rhetoric of U.S. Treasury Secretary Paul O’Neill, who declared that the U.S. would no longer bail out debt investors, money managers remain dubious. “There will be bailouts and moral hazard so long as there is foreign policy,” says Ashmore’s Booth. “It’s not within O’Neill’s power to do anything about that. September 11 means that the State Department now has more power than ever. Turkey was bailed out because of foreign policy objectives, and Pakistan will get a debt deal for the same reason.”

Not many markets have held up well since September 11, but emerging-markets debt has been one of them. If an Argentinean restructuring can be managed without roiling other emerging markets, the asset class will claim a greater credibility. Institutional investors that have long avoided the category might even take a second look.