Feast on the east

The shift was particularly apparent in emerging market credit, where heightened demand for the asset class enabled developing world companies to more than double their international borrowing in the four years ending May 2013.

By contrast, the equivalent market for sovereign debt grew by about 40%, according to data from the Bank for International Settlements.

The expansion was accompanied by a significant enlargement of the emerging market corporate bond fund universe. Indeed, more than two-thirds of the 64 European-domiciled EM credit strategies, listed in Morningstar’s fund database in December, were launched during the preceding three years (although longer-established strategies from specialist providers such as Ashmore and BlueBay dominate the sector – see table).

A hunger well fed

Appetite for developing world corporate debt in the first five months of 2013 was such that Brazilian energy giant Petrobras was able to sell $11bn (€8bn) of debt to overseas investors – the largest foreign sale of emerging market credit on record.

Despite the success of the deal, some commentators were already raising concerns about the health of the rapidly-expanding sector, including Michael Henderson, an emerging markets specialist at Capital Economics.

In a client report published on 16 May, Henderson warned that the “explosion” of international debt issuance by EM companies had been skewed towards financial institutions, leaving Turkish and Russian banks particularly vulnerable to a tightening of external credit conditions.

In addition, an uptick in speculative-grade emerging market default rates – to above the global average, for the first time since 2002 – suggested developing world firms were “struggling in the weak economic climate”.

Debt dyspepsia

However, no one foresaw the sell-off in emerging market assets that ensued less than a week later, as fears arose that the US Federal Reserve would wind down its quantitative easing programme earlier than anticipated.

The turmoil is recorded in the performance of the JP Morgan Corporate Emerging Markets Bond Index (CEMBI), which plummeted more than 8% in the month following Fed chairman Ben Bernanke’s “tapering” remarks, made during his testimony to the US Congress’s Joint Economic Committee on May 22 (see line chart).

There was a similarly marked deterioration in appetite for EM credit among the fund selectors polled by Expert Investor Europe, as the proportion planning to increase their allocations fell by 50% in the second half of 2013 (see bar chart below).

EIE editorial panellist Tristan Delaunay, chief executive officer of Paris-based multi-manager boutique Athymis Gestion, was among those professional investors who headed for the exit. He began using the asset class in 2012 but says its appeal is diminished by its sensitivity to US interest rates – a problem yet to be adequately addressed by fund managers.

“The duration is too long, too heavy and you suffer too much when interest rates are rising in the US,” Delaunay explains. “In the European credit asset classes, we find portfolio managers who are hedging the duration. But in emerging markets, it’s maybe too young an asset class to build this kind of sophisticated management.”

While Delaunay retains a small allocation to New Capital Wealthy Nations Bond – a specialist Stratton Street portfolio investing in the sovereign and corporate debt of countries which are net creditors internationally, including Qatar, the United Arab Emirates, Taiwan and Saudi Arabia – this holding faces an uncertain future.

“The managers want to reduce duration in the portfolio, but it’s tough for us to suffer from this kind of position right now,” he adds. “We are not sure whether we will manage to keep it.”

Short-term gain

However, some investors sense a buying opportunity.

Christa Janjic, a fixed income economist at Zurich-based Wellershoff & Partners, says what she calls “the surprise non-tapering” last September – and the subsequent decline in expectations for a near-term reduction in US asset purchases – prompted her firm to advise an increase in EM credit exposure on a short-term, three- to six-month, investment horizon.

“Prior to the summer, from our perspective, [EM corporate bonds] were too expensive and priced like investment grade,” Janjic adds.

“After the sell-off, they ended up being high yield bonds again, which is where we expect them to be. So we recommended that clients should get into these bonds – not strategically, but tactically.

“And we had the response from some, who said it was actually a perfect opportunity for them to start their exposure to emerging market bonds. So for these clients, this was a strategic decision to get into these bonds – and to build-up a long-term position.”

Thomas Romig, responsible for the 12-strong multi-asset management team at Union Investment, had almost zero exposure to emerging market corporate bonds throughout 2013, but says the asset class became more attractive on a risk/reward basis.

He notes that EM credit was more stable than its sovereign counterpart during the sell-off, owing to its shorter duration and greater exposure to Asia – a region which proved relatively resilient, compared with emerging territories such as Latin America.

“I was not surprised [by the sell-off] because it was the most fashionable area of fixed income, and you had many investors who only had off-benchmark positions – so you had fresh money which was not very sticky,” Romig says.

“It was a typical reaction to uncertainty. But when tapering takes place, I think the markets will be used to the discussion. I would expect much calmer reactions than we saw in May/June to the asset class – because investors have had time to re-assess the story.”

Romig, whose group runs 21 portfolios with combined assets of about €9bn, two-thirds of which is held in third-party funds, adds that he is considering increasing his EM credit exposure.

Favoured fund holdings in this area include JP Morgan Emerging Markets Corporate Bond and UBAM EM High Yield Short Duration Corporate Bond, and Romig’s team has looked closely at specialist short-duration strategies.

Any ‘first step’ into the asset class would likely focus on hard currency securities.

“[EM credit] gives us some pickup, and in the next one to three years it will be hard to find good income-generating investments without being in the equity market,” he says.

“It also includes companies from Singapore, [South] Korea and other countries which you wouldn’t normally put into the emerging market bucket. So emerging market corporate bonds is a good place to look, and it is still under-researched.”

Going local

But is developing world credit an attractive bet for investors looking beyond the next few years? Yes, says Romig. He highlights the growth of the Asian pension system and fund industry, which should support the growth of the asset class in the decades ahead.

“We see a more stable pool of local investors for emerging market corporates, so there’s a natural demand for that kind of issuance, coming from the region itself,” he adds.

Even Delaunay is confident on the longer-term picture, despite his move out of the asset class, and his misgivings on the quality of products available to investors.

He says: “With the same kind of rating you’ve got a better company in the emerging markets. With the same kind of rating you’ve got a larger spread for emerging market issuers. So you’ve got a lot of positive differences for emerging issuers. The story is still there.”