Emerging bond markets move into mainstream investment thinking

The broad asset class we think of as emerging market debt has been evolving over the last few years. The end of the global mega credit cycle, so damaging to banking systems and sovereign debt ratios in many developed economies, left many emerging and developing economies relatively unscathed.

Whilst pre-emptive IMF activity following the March 2009 G20 and IMF meetings provided a big confidence boost for Emerging Markets (EM) in general, the principle driver behind EM’s strong position was the dramatic monetary and fiscal response from the major developed economy central banks to their collective crisis, which in turn had an unintended and positive consequence for EM countries. Near zero short term interest rates in Japan, the EU and the US combined with the impact of Quantitative Easing (QE) and deflation fears on developed economy bond markets gave EM debt a comparatively high yield status, encouraging inflows into the EM debt sector over the last several months.

But a relatively high yield is not the only attraction, especially since the near two year rally from the trough of October 2008 reduced the yield on the most followed US dollar denominated EM External debt benchmark index to a recent low of below 5.60%, a spread of around 3% over US Treasuries.

The prospect of a comparatively modest future debt issuance at the sovereign level gives a compelling inducement to own EM debt, particularly local market debt. For the first time in the history of financial markets it is now easier to forecast the likely amount of debt to be issued by EM Sovereign borrowers than it is for developed countries over the next several years.
Demographically, EM countries aren’t hindered by ageing populations like developed countries, suggesting that servicing debt will be unproblematic thanks to growing revenue streams generated by youthful populations.

Foreign exchange reserves have been rapidly accumulated by many EM central banks as they attempt to contain the impact of inward investment flows on the strength of their currencies. EM countries have become increasingly robust net creditors, strengthening their financial position relative to developed market countries and challenging the belief that developed countries will escape a real depreciation in their currencies and value of their bonds over time.

But perhaps the core argument favouring the investment markets of EM countries is the genuine improvement in their long term growth prospects, regardless of whether developed economies experience sub-trend recoveries. Forecasts for GDP of EM countries over the next 20 years suggest the BRICs and “Next 11 economies” are going to grow at an average 6%, compared with developed economy GDP growth of 3%.

Growing investment and trade between EMs makes them less reliant on developed world growth. Last year, direct overseas investment by Chinese companies totalled $56.5bn with around 70% of the money invested in other parts of Asia and 15% in Latin America. Chinese officials recently predicted investment would reach $100bn by 2013.

For today’s investors, the challenge is to grasp their claim on future growth through emerging markets assets while they are still thought of as ‘emerging’. The surprise of the next decade may be that EM investment institutions, including Sovereign Wealth Funds and EM global corporations, dominate EM investment inflows despite an expansion of interest from developed market investors.

Unless stated otherwise any opinions expressed are those of Aviva Investors.  They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature.

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