Emerging market debt tipped as prime opportunity of investors

News - Banking

Written by Ray Clancy

Friday, 24 September 2010 08:14

Emerging market debt offers a prime opportunity for investors as research shows it has outperformed major asset classses over the last 15 years on a risk adjusted basis, experts claim.

Emerging market debt’s weak correlation with developed world bond markets means that now is a prime opportunity for investors to enhance returns and reduce risk through diversification, according to Legg Mason affiliate Western.

These economies are continuing to outperform developed economies, thanks to fiscal and monetary reforms and favourable secular and demographic trends that have made them significantly less vulnerable to external shocks compared with past cycles, it says.

As a result, an actively managed exposure to emerging market debt, including sovereign, quasi-sovereign and corporate issues in both local and foreign currencies, will be rewarded over the coming business cycle, according to Western.

The company cites research that shows emerging market debt has outperformed several major asset classes over the past 15 years if measured on a risk adjusted basis. For example, hard currency sovereign debt, represented by the Emerging Markets Bond Index Global (EMBI Global) and the Emerging Markets Bond Index Plus (EMBI+) each recorded a Sharpe ratio of 0.41 for the 15 years to the end of February 2010.

It says this compares favourably versus high yield bonds (the JP Morgan High Yield Index recorded a Sharpe Ratio of 0.35), equities (a 0.21 ratio for the S&P 500) and US Treasuries (0.40 for the JP Morgan US Treasury Index). The cumulative return for the EMBI Global Index was 374.93%; for the EMBI+ Index it was 400.34%; for the JP Morgan High Yield Index 214.40%, for the S&P 500 221.41% and for the JP Morgan US Treasury Index 160.04%.

‘Emerging market sovereign credit ratings have continued to be incredibly resilient both before and after the recent credit crisis and numerous emerging market sovereign ratings have been upgraded over the last few years, several of them to investment grade,’ said Mike Zelouf, director of international business at Western.

‘This contrasts sharply with advanced countries that are now being threatened with sovereign credit rating downgrades due to persistent fiscal deficits, slower economic growth and growing debt stocks,’ he added.

‘Taking exposure to emerging local markets allows an investor to benefit from a secular reduction in emerging market local interest rates relative to developed country rates as well as via nominal currency appreciation. A sector rotation strategy utilising active allocations to local market sovereign debt and hard currency corporate debt offers a unique opportunity to enhance returns in broad emerging markets strategies, while offering lower levels of risk,’ he explained.

In the Legg Mason Western Asset Emerging Markets Bond Fund, Western is focusing on higher quality bonds issued by quasi-sovereign institutions, or entities that are underwritten by governments and corporates that are essential to the ongoing recovery process in emerging economies and it aims to construct diversified country positions. Western also aims to maintain elevated levels of cash as a hedge against its corporate allocation but will gradually deploy the cash as attractive new issuance opportunities arise.