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Despite the severity of the global financial crisis of 2008–09, most emerging market (EM) countries weathered the adverse market conditions better than developed nations. In fact, in the aftermath, when the United States and other advanced economies suffered credit rating downgrades, many developing nations emerged with their credit ratings intact or upgraded. The comparative strength of emerging market economies during this period, however, was not a fluke. It was the direct result of improved macroeconomic policies and debt management practices that began more than a decade earlier.
Improved fiscal and monetary policies have strengthened EM economies; created a stronger base of domestic investors; allowed EM governments to meet a greater proportion of their longer-term borrowing requirements by issuing securities in their own currencies, instead of foreign currencies; and increased inflows from foreign investors attracted to new sources of yield and return potential, which, in turn, has provided the capital for more growth. As a relatively new and distinctive asset class, the local-currency bond market has caught the interest of both institutional and retail investors—and, we believe, for good reason.
Defining the Asset Class
Emerging market countries are so called because their economies are said to be emerging from a state of relative underdevelopment. Typically, the category includes all of Africa, Central and Eastern Europe, Latin America, Russia, the Middle East, and Asia (excluding Japan).
Historically, EM governments were able to access foreign markets only through the issuance of bonds denominated in foreign (or "hard") currencies, such as the U.S. dollar. This left their countries particularly vulnerable to external shocks. But as their economies strengthened and global investor demand increased, many governments began to issue more debt in their local currencies and for longer maturities. In addition, as the EM countries developed credible institutions to manage monetary and fiscal policies, they opened up their markets to outside investors, further increasing both demand and supply. As a result, hard-currency funding accounts for a decreasing percentage of total borrowing for EM governments. This is an important consideration for investors because it means that opportunity in emerging markets cannot be fully explored merely by an investment in hard-currency debt. Chart 1 makes a strong case for including sovereign local-currency debt in the EM portion of a portfolio.
Source: JPMorgan (2012) and the International Monetary Fund (2012).
For illustrative purposes only and does not represent any Lord Abbett mutual fund or any particular investment.
Most EM countries that issue local-currency bonds are captured in the J.P. Morgan Global Bond Index—Emerging Markets Global Diversified (or GBI-EM Global Diversified),1 which includes 16 countries: Brazil, Chile, Colombia, Hungary, Indonesia, Malaysia, Mexico, Peru, the Philippines, Poland, Romania, Russia, South Africa, Nigeria, Thailand, and Turkey.
For bonds to be included in the GBI-EM Global Diversified index, they must be regularly traded, fixed-rate, domestic government security bonds that international investors have ready access to. Two notable exclusions from the index are China and India. Although local-currency bonds are available in both nations, local capital controls make it difficult for foreign investors to participate in these markets.
Meanwhile, EM local currency bonds have grown rapidly—from $863 billion at the end of 1999 to nearly $5 trillion at the end of 2011, roughly comparable to the combined value of local-currency government securities of France, Germany, and the United Kingdom. Of course, the U.S. bond market continues to be the largest and most liquid securities market in the world, with the value of bonds outstanding equaling $37 trillion.2
For many years, emerging markets were remembered for one thing: trouble. Unstable governments and unorthodox monetary and fiscal policies were the rule rather than the exception. The results of those ill-conceived policies became clear in the two decades between 1980 and 2000 when a total of 34 EM countries defaulted on or rescheduled their external debt, some of them more than once. Excessive foreign currency borrowing had left them vulnerable to interruptions in international capital markets, resulting in liquidity crises when those markets froze and governments were unable to roll over their foreign currency obligations. EM countries also suffered from inflation and massive currency devaluations that, when combined with high debt levels, resulted in unmanageable debt-servicing costs.3
But it was that crisis-ridden period that drove home the need for sounder macroeconomic policies and debt management practices. According to the World Bank,4 between 2000 and 2007:
Domestic debt portfolios went through major shifts in composition and maturity, reducing the exposure of these countries to shifts in the economic cycle and market sentiment. In all regions, debt managers prepaid short-term debt through buybacks or exchanges and issued longer-maturity bonds, lowering interest rate as well as refinancing risk. A common denominator of the transformation of debt markets has been the expansion and growth of the local investor base, especially nonbank financial institutions, most notably pension funds, but also insurance companies and mutual funds. In the 1980s and 1990s, for example, local financial institutions were generally underdeveloped. By 2005, however, they were providing a significant local bid for domestic-currency debt. This increased the liquidity of the markets, further enhancing their "investability," and encouraging more issuance for additional improvements.
Effects of the Financial Crisis
The 2008-09 global financial crisis provided a useful test of the ability of the newly strengthened EM economies and their bond markets to weather extreme global market conditions. And, although EM economies were adversely affected, they rebounded more quickly than the developed nations. Unlike the advanced economies, EMs on average did not have large government and private debt overhangs. According to the International Monetary Fund, at the government level, EM debt-to-GDP ratios today average 36%, compared with 104% for developed markets. At the consumer level, personal debt also is generally low, reflecting the relative youthfulness of the personal credit sector in EM economies. EM economies also were underpinned by ample macroeconomic stimulus as well as external and internal demand.
In the bond markets, according to a World Bank study, much of the volatility in returns occurred through the foreign-currency channel (not bond prices in local currency), insulating local currency investors. EM domestic bonds, however, were not untouched by the crisis. The World Bank study points out that an important source of selling pressure on the asset class was forced liquidations by foreign investors due to the relatively low collateral value of EM bonds.5
While foreign investors can be a source of selling pressure on the asset class in times of crisis, we believe the stability of the market for foreign investors has improved in recent years with the growth of domestic demand. Many EM countries have implemented pension reforms, which are increasing demand among local pension funds for local-currency long-term bonds as a hedge against long-term liabilities. In fact, increased acceptance of local currency debt by institutional investors globally, with their long-term investment horizons, helps provide lower volatility for the asset class.
From a multi-asset perspective, some allocation to EM local currency debt confers portfolio diversification benefits. But as the financial crisis demonstrated all too well, global shocks can increase the correlation of asset returns, particularly during extreme events, reducing diversification benefits for investors. And throughout much of the history of emerging markets, global factors have played a significant role in the performance of local-currency debt—but that may be changing.
The Bank for International Settlements (BIS),6 for example, has noted that, in recent history, "domestic factors are having a larger impact than global factors" on the asset class. Certainly, we've seen a decoupling between developed nations and emerging markets in recent years in terms of credit ratings, with the latter experiencing more upgrades than downgrades and the former trending downward because of their weak fiscal and growth prospects. To the extent that yields on these assets are increasingly determined by domestic growth and monetary conditions rather than global factors, they could offer a much-needed diversification opportunity to investors.
One interesting and related development is the fact that since 2008, yields on EM local-currency sovereign bonds have tended to drop, rather than increase, in response to worsening global risk sentiment. This is in contrast with their historical performance, during which domestic yields typically worsened in response to eroding global risk sentiment.
According to the BIS, during 2000–07, local-currency bonds behaved like a risk asset, with their yields rising about 20 basis points (bps) in response to a 10 percentage-point increase in the VIX. In contrast, between 2008 and 2011, a 10 percentage-point rise in the VIX produced a 30 basis-point drop in local-currency government bond yields, behavior more akin to a "safe" asset.7 Of course, as current (June 2013) volatility signifies, one hesitates to label this asset class a "safe harbor."
Finally, by purchasing EM domestic bonds instead of bonds denominated in hard currencies, foreign investors are gaining exposure to EM currencies, which have shown secular appreciation trends—most likely a major motivator for investors. We expect the differential in growth rates between EM economies and the developed nations to continue to act as a magnet for capital flows into emerging markets and to the local-currency bond market in particular.
Performance of Emerging Markets Local Currency Bonds
Although diversification benefits are an important consideration from a total portfolio perspective, probably the chief driver of asset flows into the local-currency bond market has been the search for yield and return potential in the current low interest-rate environment. In fact, the growing popularity of EM local-currency debt is no mystery when its strong performance versus other major asset classes in recent years is considered. Of course, there is no guarantee that this trend will continue in the future.
According to Morningstar, since 2002, EM local currency debt (as represented by the JP Morgan GBI-EM Global Diversified Index) has had an annualized return of 11.4%, compared with 8.3% for the S&P 500® Index (as of May 31, 2013).
The strong performance of the asset class also stands out when we look at the risk-adjusted returns, as measured by the Sharpe ratio (which is the ratio of median annual returns to volatility of returns). Compared with other asset classes, EM local-currency government bonds have had one of the best Sharpe ratios in both good and bad times. During 2002-07, for example, the Sharpe ratio of EM local-currency government bonds was 0.9, compared with EM hard-currency bonds8 (denominated in U.S. dollars) and EM equities,9 both at 0.5. During 2008–12, when investor risk sentiment worsened, the Sharpe ratio of local-currency government bonds, at 0.3, still continued to be the highest.10
Of course, like any other asset class, local-currency government bonds have had their ups and downs (and past performance, obviously, is no indication of future performance). Performance was strong during 2003–07, a period of low global risk aversion, with EM local-currency government bonds yielding annual returns of about 9%, which was significantly greater than the returns on U.S. Treasuries of about 4%. And investors demanded a substantial premium for investing in the asset class.11
As risk sentiment deteriorated during the run-up to the global financial crisis in 2008, performance of EM local-currency government bonds dropped, but it rebounded as early as the end of 2008. Performance dipped during the sovereign debt crisis in the eurozone, but emerging market local-currency government bonds came back strong again on the commitment of central banks to support global economic growth. At this writing (June 2013), even as we are experiencing some drawdowns in the asset class (probably more related to hedged positions in interest rate swaps than to the "real" money in the bonds themselves), a look at the yields available in EMs as of May 31, 2013, compared with those of government bonds in developed markets reveals why this asset class continues to be a popular addition to a global portfolio. (See Table 1.)
Source: J.P. Morgan; data as of May 31, 2013.
Past performance is no guarantee of future results.
For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Emerging market securities may be less liquid and more volatile than U.S. and longer-established non-U.S. markets.
Understanding the Risks
Understanding the risks of the EM local-currency government bond asset class cannot be achieved by viewing the asset class as a whole. Instead, it requires careful analysis of each individual issuer and market—which is the role of active managers.
Nonetheless, we can offer some generalizations concerning the three broad categories of risk usually associated with the asset class.
The first of these is default risk. As our brief discussion of the 1980s and 1990s demonstrated, emerging markets countries have had an unfortunate history of defaults. But these events were driven largely by those countries' heavy reliance on hard currencies for funding. Countries did not have sufficient foreign reserves to pay back the debt when circumstances made it necessary. Issuing in local currencies (which can be printed at the will of the local government) makes that a nonissue. For that reason, local-currency debt typically has been rated higher than hard-currency debt. Given the EM countries' marked improvements in economic and fiscal policies, we expect sovereign default risk to remain low in the coming years.
Investing in local-currency bonds, by definition, requires investing in local currencies. Currency risk is the most volatile component of this market. A U.S. investor, for example, will face currency risk if the currency in which the debt is issued depreciates. This is because the value of the U.S. investor's investment will decrease.
Finally, government intervention in the form of capital controls and other types of market manipulation can never be ruled out in any market—whether emerging or developed. Understanding the political trends and anticipating policy changes are an important part of the risk management that investors need to engage in when considering investment opportunities in EM markets.
As with all risks, the key for investors is to make sure that they are paid an appropriate premium for taking it on. Generally speaking, we think emerging market local-currency investors currently are being compensated for the additional risk they may be assuming in these markets.
Supported by stronger fundamentals, emerging markets today currently are attracting investors for their yield and return potential. This is particularly the case in the government-issued local-currency market, where longer maturities are attracting institutional investors, both domestic and foreign. Foreign investors seeking to diversify their exposure to the U.S. dollar are also drawn to local-currency debt, especially as local currencies strengthen, reflecting relatively strong economic growth. Moreover, the creditworthiness of EMs has improved. According to Fitch Ratings, 2012 was the third consecutive year that emerging market sovereign debt experienced more upgrades than downgrades (although the upward momentum slowed in 2012), in sharp contrast to the developed nations, where public and private indebtedness remains a burden.
Participation in these markets, however, requires careful analysis of economic, political, and currency risks. As an investment opportunity, the local-currency government bond market is far from homogeneous. Individual nations and issuers can have dramatically different growth prospects and risk outlooks. And global factors can still influence risk sentiment in this market overall, even though individual countries may be in a stronger position than in the past to weather adverse risk perceptions and/or events. For most investors, active management of both risk factors and opportunities by investment professionals experienced in these markets is highly advisable.
Risks to Consider: Foreign investments generally pose greater risks than domestic investments, including greater price fluctuations and higher transaction costs. Special risks are inherent in international investing, including those related to currency fluctuations and foreign, political, and economic events. The securities markets of emerging countries tend to be less liquid, to be especially subject to greater price volatility, to have a smaller market capitalization, and to have less government regulation and may not be subject to as extensive and frequent accounting, financial, and other reporting requirements as securities markets in more developed countries. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions. The risks associated with derivatives may be different from and greater than the risks associated with directly investing in securities and other investments. In addition to other risks, derivatives also involve the risk of mispricing or improper valuation and the risk that changes in the value of the derivative may not correlate with the value of the underlying asset, rate, or index. Because derivatives may involve a small amount of cash relative to the total amount of the transaction, the magnitude of losses from derivatives may be greater than the amount originally invested. If an investor incorrectly forecasts these and other factors, performance could suffer. Foreign currency exchange rates may fluctuate significantly over short periods of time. They generally are determined by supply and demand in the foreign exchange markets and relative merits of investments in different countries, actual or perceived changes in interest rates, and other complex factors. Currency exchange rates also can be affected unpredictably by intervention (or the failure to intervene) by U.S. or foreign governments or central banks, or by currency controls or political developments.
Bonds issued or guaranteed by foreign governments and governmental entities (commonly referred to as "sovereign debt") present risks not associated with investments in other types of bonds. The sovereign government or governmental entity issuing or guaranteeing the debt may be unable or unwilling to make interest payments and/or repay the principal owed. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
The emerging markets local currency bond market may not perform in a similar manner under similar conditions in the future.
Glossary of Terms
A basis point is 1/100 of a percent, so 100 basis points is 1%.
Correlation is a statistical measure of how two securities move in relation to each other.
Debt-to-GDP ratio is a measure of a country's federal debt in relation to its gross domestic product (GDP).
Gross domestic product is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis.
An interest rate swap is an agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount.
Maturity refers to a finite time period at the end of which the financial instrument will cease to exist and the principal is repaid with interest.
The S&P 500® Index is a domestic equity index consisting of 500 stocks representing approximately 75% of the total U.S. equity market, focusing on the large cap sector of the U.S. equities market. The index includes the 500 leading companies in leading industries of the U.S. economy.
The yield curve shows the relation between the (level of) interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency.
VIX is a trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 Index options.
Neither diversification nor asset allocation can guarantee a profit or protect against loss in declining markets.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.