Emerging-market debt a good mid-term bet

Brett Diment is the head of emerging markets on the fixed-income team at Aberdeen Asset Management in London. He joined Aberdeen via the acquisition of Deutsche Asset Management's London and Philadelphia fixed-income businesses in 2005, where he previously held the same role since 1999. Diment joined Deutsche AM in 1991 as a graduate and began researching emerging markets in 1995.

Here he discusses Aberdeen AM's approach to investing in the asset class. He looks at the attractive outlook for emerging markets and believes that the asset class will produce solid returns over a three- to five-year period based on improving fundamentals and rising growth expectations.

Aberdeen AM's global assets under management totalled $234.3 billion at the end of September, while its Asia-Pacific AUM stood at $55.9 billion on August 31. It doesn't break the figures down by emerging-market sectors.

What is your process for investing in emerging-market debt?

We focus on the entire emerging-market debt universe to maximise the return potential of our funds. We conduct comprehensive country research, set in the context of global economic developments, which forms the foundation of our investment process. We look at factors such as key macroeconomic variables, the political environment, fiscal and monetary policy developments and major risk. This is coupled with analysis of market technicals, such as the nature of instruments, relative value, liquidity and demand-supply imbalances.

What importance do you place on the benchmark?

We are aware of the benchmark but it does not drive our investment decisions. We are comfortable taking positions outside the benchmark and actively do so where we see opportunities. Our own research is key to our investment decisions, therefore we are not constrained by what is in the benchmark. We are conscious of the benchmark, however, in that we monitor any significant deviations to ensure that we control beta risk in our portfolios.

Given the better performance in emerging-market debt recently, do you still see opportunities?

The long-term growth prospects in emerging markets are supported by solid fundamentals and the belief that these countries are better positioned today to deal with the fallout from the global credit crisis. Emerging markets are generally more self-sufficient and not so dependent on exports to the developed world as they were in the past. An example of this is that China is now the top export market for Brazil.

That's not to say that emerging-market countries will enjoy high rates of growth while consumers in the developed world are on their backs, as has been the case over the past year. Emerging-market countries have come a long way from the crisis days of the 1980s and the 1990s, when self-inflicted wounds brought their economies to their knees. We believe they are more capable today of dealing with perhaps the worst global financial crisis in our lifetime, due to stronger balance sheets and more prudent macroeconomic policies.

In summary, we think emerging-market countries should see benefits from the rising growth differentials between developing and developed countries, resulting in increased inflows into the asset class.

How have the added resources from the International Monetary Fund and the new credit facility helped?

The combined measures significantly reduced the 'tail risk' in emerging markets, providing ample support for developing countries with little to no access to external financing. This has resulted in firmer currencies and reduced credit risk premiums.

Do you feel policy easing has come to an end and, if so, how do you feel this will affect emerging markets?

The policy easing cycle has effectively run its course in emerging-market countries, with central banks in Brazil, Indonesia, Mexico, South Africa and Turkey likely to remain on hold after a series of interest rate cuts over the past year. We do see scope for further rate cuts in Hungary, which was late to join the rate-easing cycle due to the instability in the local market during the first half of 2009.

However, in the absence of another sharp downturn in global growth expectations, we believe the next move for emerging-market central banks will be upwards, with monetary tightening likely to commence in the second half of 2010. An increase in policy rates will be likely to weigh on local rate markets, with long-dated bonds likely to underperform in such an environment.

But at the same time, an increase in the interest rate differentials between developed countries and developing-country bond markets may prompt renewed interest in the carry trade (borrowing low-yielding and lending high-yielding currencies), which in turn could result in selective appreciation of emerging-market currencies.

Which areas of emerging markets do you find interesting at the moment?

We continue to like high-yield sovereigns such as Argentina and Ukraine, where the market is still pricing in a high degree of default risk. In addition, we remain overweight a number of smaller countries in the index, such as Gabon, Georgia, Ghana, Iraq and Pakistan. We are also selectively adding to our corporate bond exposure, with a number of high-grade corporates looking to come to the market with attractively priced new issues. Lastly, we think a continued normalisation in risk appetite will bode well for emerging-market currencies, which should benefit from renewed capital flows to the developing world.

Conversely, are there any areas you would avoid in the current environment and if so, why?

We are underweight BBB-rated sovereigns such as Brazil, Mexico and Peru, where we see little value in US dollar bond issues. We are also underweight BB-rated sovereigns, with Colombia, the Philippines and Turkey also trading at excessively tight spreads.

Can you give an example of a country you like and tell us why you like it?

Indonesia appears to be one of the few emerging-market sovereigns poised for upgrades, reflecting a positive 2009 growth outlook, improving debt dynamics, a structural reform programme and stable political outlook. We think Indonesia could make the leap to investment grade over the next three to four years, as it is currently rated just two notches below investment grade by two of the rating agencies.

Can you give an example of a corporate you like and tell us why?

A corporate we like is Homex, Mexico's largest home builder. In Mexico, there is unmet demand for low-income, affordable housing and one of the main focuses of Homex is this segment. In Mexico, the housing market is different to that of the US in that government mortgage lenders take on home buyer's credit risk directly, immediately after the sale of the housing, and uniquely they have access to a worker's salary -- so a worker receives his or her salary net of their mortgage payment.

As a result, we believe there is a viable regulatory structure underpinning the industry and we are comfortable with that. We also feel the company has the requisite business and financial skills, as well as good corporate governance to perform well in the market.

If investors already have exposure to emerging markets via equities, why should they invest in emerging-market debt?

Aside from the opportunities available in equity markets, there are some quite large bond markets in emerging markets that are by no means fully developed, but that are maturing. Returns have been attractive, volatility low and diversification benefits substantial.

On the credit side, debt markets have grown substantially, with governments issuing longer-dated issues and thereby creating a reference yield curve that had hitherto been lacking in many markets. Both dollar-bond and local-currency issuance has picked up, and this of course reflects the improving creditworthiness of sovereigns (and corporates), as well as relatively low global interest rates that have reduced the costs of issuance.

What do you feel is the benefit of investing in emerging-market local-currency debt?

Emerging-market local-currency debt has explicit exposure to currency and interest rate dynamics, and the investor base is dominated by local institutional investors. The asset class offers broad geographical diversification, as well as being a natural hedge against dollar weakness. It also offers the potential for currency appreciation and diversification for hard-currency emerging-market debt portfolios. Local-currency debt is a relatively new asset class, and mispricing inefficiencies exist. As active managers, we can take advantage of opportunities in this area.

 When do you think is a good time to invest?

This is a challenging question in the current environment; emerging-market debt has been one of the best-performing asset classes in 2009. While it's always difficult to jump into a big market rally, what we would emphasise is that over a three- to five-year period, we think investors will enjoy good, solid returns from an asset class that is clearly benefiting from a combination of improving fundamentals and rising growth expectations.