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An Introduction to the
Emerging Market
Debt Asset Class
Emerging-market debt has become a recognized asset class in its own
right, with a maturity mirroring that of its constituent countries. While
recent performance and asset flows in emerging-market bond funds may
appear atypically strong, we believe these economies’ outperformance is
supported by sound underlying fundamentals.
2
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010F
2011F
of the crisis points to a new maturity. Current account surpluses,
increasing currency reserves, improving political stability, favorable
As of November 2010
demographics and flexible exchange rates are all positive indicators
1 Includes 19 EM countries
of the ascending power of emerging markets. These fundamental Forecasted or estimated results do not represent a promise or guarantee of
changes hold important implications for investors who wish to align future results and are subject to change.
their portfolios with this dynamic new reality. Source: World Bank, Bloomberg
Rather than being an outlier, we see recent large flows into the As Exhibit 1 shows, the divergence in recent growth patterns and
emerging market debt asset class as representing a recalibration prospects could not be starker.
from a historical underweight. We estimate that at current levels of
inflows, it will take global investors more than five years to become Exhibit 2 shows that there has been a clear shift in the growth drivers
market weight in emerging market debt. of the world—from OECD member countries to emerging markets.
Despite these very positive trends, it must be stressed that emerg- Less Debt
ing markets are not homogenous. We will likely see differentiated Although emerging markets are typically known for high rates of
returns across countries and regions. So while we are bullish overall growth, what is perhaps surprising is their low levels of debt. As
on the asset class, country selection and credit work is essential to Exhibits 3 and 4 illustrate, emerging-market fiscal deficits are at
construct a diversified emerging market debt portfolio. less than half the level of developed markets, while their debt-to-
GDP ratios also exhibit long-term stability.
Better Macroeconomic Fundamentals
Leading Global Growth
Exhibit 3
The global crisis has put into sharper focus a shift in the balance of Strong Fiscal Indicators in Emerging Markets
(Nominal Deficit as a Percentage of GDP)
power within the world economy.
2007 2008 2009 2010F
While many developed economies are grappling with public and
Developed Market Economies -1.1 -3.4 -8.1 -8.5
consumer debt burdens, developing countries have been driv-
United States -1.1 -3.1 -8.8 -11.1
ing the recovery phase, showing more resilience and returning to
United Kingdom -2.6 -6.2 -13.2 -12.8
growth more swiftly than their developed counterparts.
Japan -2.5 -2.7 -8.7 -8.0
Euro Area -0.6 -1.9 -5.9 -7.2
Emerging Market Economies 0.6 -0.6 -3.8 -2.8
Exhibit 1
Latin America -0.2 -0.8 -3.0 -2.4
Real GDP Growth Rate
Brazil -2.2 -2.0 -4.1 -2.0
(%)
Mexico 0.0 -2.0 -2.1 -1.4
10
8 Eastern Europe 1.0 -0.1 -6.2 -4.8
6
Hungary -4.9 -3.8 -3.9 -4.4
4
2 Poland -1.9 -3.6 -5.6 -2.8
0
Russia 5.4 4.1 -6.3 -4.0
-2
-4 Emerging Asia 0.9 -1.3 -3.8 -2.8
2002 2003 2004 2005 2006 2007 2008 2009 2010F 2011F
China 0.6 -0.4 -3.3 -2.9
Emerging Markets¹
Developed Markets Korea 3.8 1.3 -2.7 -4.1
Exhibit 6
As of December 2010 Hard Currency Issuance – Sovereign and Corporate
1 Includes 20 EM countries
Forecasted or estimated results do not represent a promise or guarantee of EM sovereign and corporate borrowing needs are far advanced with U.S.
future results and are subject to change. $186 billion issued so far this year versus U.S. $256 billion forecast
Source: Moody’s, Lazard (U.S. $ B)
250
200
Global Integration
150
This strong position has afforded many developing countries the
luxury of free-floating currencies, which, owing to strong inflows 100
Exhibit 5
Total Global Bond Market Capitalization
US Aggregate and High Yield $13.4 trillion Exhibit 7
Hard and Local Currency Index Market Values
Global (ex-U.S.) Aggregate $19.5 trillion
As of December 2010
1200
Source: J.P. Morgan, Bank of America Merrill Lynch
800
0 10
May Jul Sep Nov Jan Mar May Jul Sep Nov
Exhibit 8 09 09 09 09 10 10 10 10 10 10
Cumulative Inflows into Emerging Markets Debt
External [LHS]
Local [LHS]
(U.S. $B)
Local % of total [RHS]
80
2006 75.1
As of December 2010
70 2007
2008 Source: J.P. Morgan, Bloomberg, EPFR
60 2009
2010
50
41.9
40 38.1
34.4 Exhibit 10
30
Total AUM in EM Bond Mutual Funds¹
20
20 0.9
15
As Exhibit 8 shows, this year’s inflows have already exceeded last 0.7
10
year’s total, while Exhibit 9 illustrates how the composition of
0.5
5
flows is shifting more towards local currency and blended mandates.
0 0.3
It is also significant that the inflows have been coming from a more 2001 2002 2003 2004 2005 2006 2007 2008 2009 YTD
2010
diverse and increasingly institutional investor set. While in the past,
Total AUM in U.S.-based EM Bond Mutual Funds1 [LHS]
investments in emerging markets debt were seen as tactical plays, Total AUM in U.S.-based EM Bond Mutual Funds1 as a
the money flowing into the asset class today is coming from pension Percentage of Total AUM in U.S. Fixed Income Mutual Funds2 [RHS]
funds, Asian investors, sovereign wealth funds and central banks. As of November 2010
This shift in the investor base—towards longer-term asset alloca- 1 The universe was defined by using the Morningstar category “EM Bond“
2 Excluding convertibles
tors—is leading to a less volatile environment for the asset class.
Source: Strategic Insights
5
For example, pension funds typically have a close-to-zero alloca- favor emerging-market assets, and we expect the shift of investor
tion to emerging-market debt, and, as can be seen in Exhibit 10, capital into emerging-market debt to continue at a brisk pace.
assets in emerging-market bond mutual funds account for only
1.5% of the total assets invested in U.S. fixed-income mutual Why Emerging Markets Debt Now?
funds. Furthermore, as mentioned earlier, current structural trends
Strong Risk-adjusted Returns
Exhibit 12
History of Emerging Market Sovereign Spreads
Russian Default
1400 LTCM Blowup
BB+
Argentina Default
1200
Brazil Election Turmoil
Mexico upgraded to
1000 Investment Grade Russia upgraded to BB
Investment Grade
800 Global Financial Crisis
Local Debt Issuance Greek
Surpasses External Debt Debt Crisis BB-
600 Issuance Brazil Upgraded to
Investment Grade
400
B+
200
B
0
Dec 97
Mar 98
Jun 98
Sep 98
Dec 98
Mar 99
Jun 99
Sep 99
Dec 99
Mar 00
Jun 00
Sep 00
Dec 00
Mar 01
Jun 01
Sep 01
Dec 01
Mar 02
Jun 02
Sep 02
Dec 02
Mar 03
Jun 03
Sep 03
Dec 03
Mar 04
Jun 04
Sep 04
Dec 04
Mar 05
Jun 05
Sep 05
Dec 05
Mar 06
Jun 06
Sep 06
Dec 06
Mar 07
Jun 07
Sep 07
Dec 07
Jun 08
Sep 08
Dec 08
Mar 09
Jun 09
Sep 09
Dec 09
Mar 10
Jun 10
Sep 10
Dec 10
Mar 08
Sovereign Spread represented by stripped spread (in bps) of J.P. Morgan EMBI Global Diversified Index [LHS]
Average credit rating of the J.P. Morgan EMBI Global Diversified Index [RHS]
As of December 2010
Source: J.P. Morgan, Lazard
6
Exhibit 13
Sovereign Spreads Are Still Above pre-Crisis Levels
800
600
362 bps
400
156 bps
200
0
South Africa
Mexico
Russia
Bulgaria
Hungary
Peru
Qatar
Kazakhstan¹
Indonesia
Turkey
Venezuela
Ukraine
Lebanon
Argentina
Philippines
Vietnam
China
Brazi
As of 31 May 2007¹
As of 31 December 2010
Average, by group, on 31 December 2010
As of December 2010
1 Did not have bonds on 31 May 2007; used tightest spread level since issued
Source: Bloomberg, Standard and Poor’s
Exhibit 14
EM Real Yields Still Compelling on a Historic Basis
0
Dec 02 Sep 03 Jun 04 Apr 05 Jan 06 Oct 06 Aug 07 May 08 Feb 09 Dec 09 Sep 10
-1
-2
Jan 06 May 06 Sep 06 Jan 07 May 07 Sep 07 Jan 08 May 08 Sep 08 Jan 09 May 09 Sep 09 Jan 10 May 10 Sep 10
As of November 2010
Source: J.P. Morgan
7
over U.S. Treasuries, approximately 145 basis points off historic ize on country selection. We believe this is where the real value is
lows, and in some cases far higher. for an investor who is able to differentiate on intrinsic value.
Exhibit 15 Exhibit 15 shows real exchange rates levels versus their 10-year
Real Effective Exchange Rates averages. Currencies of countries listed on the negative side of
(Current versus 10-year Average) the chart are trading at a premium to 10-year averages. While
there has been overall appreciation, we believe that the significant
Argentina
Korea improvement in external fundamentals—a key driver of currency
Slovenia
Morocco valuation—in these countries are not fully priced in, and that many
Philippines “Cheap” currencies will continue to appreciate versus their developed
Mexico
India market peers. As such, we continue to support allocations to local
Malaysia
Saudi Arabia currency at this time, though opportunities are on a selective basis.
Kuwait
Hungary
Poland
Emerging Market Domestic Interest Rates Are
Turkey Favorable
Venezuela
Peru Looking at domestic interest rates, we believe that the re-rating
Slovak Republic
China of macro fundamentals has been more priced in for hard currency
Singapore
Bulgaria yield curves as compared to local currency yield curves. The y-axis
Colombia in Exhibit 16 shows the 5-year local rate differential versus the
Czech Republic
Chile U.S. dollar, while the x-axis shows average inflation differentials
Thailand “Expensive”
South Africa versus the United States. Therefore, countries above the diagonal
Russia line have positive real rates versus inflationary pressure. As the chart
Indonesia
Brazil shows, there are numerous opportunities for real rates to converge
-40 -30 -20 -10 0 10 20 in the emerging world, another benefit for local currency investors.
(%)
As of December 2010
Source: J.P. Morgan
Positioning and Outlook
In view of this broad backdrop, what are the implications for inves-
tors for the near future?
Exhibit 16
EM Domestic Interest Rates Are Favorable Asset Allocation
5-year Local-USD Rate Difference We believe that near-term price movements in emerging-market
10
BRA
debt and currencies will be more dependent on economic con-
8 ditions in the developed world than on those in developing
TUR countries. We have relatively high conviction that core growth
6 rates in emerging markets will sustain at elevated levels regardless
ZAF RUS
COL of various permutations in the developed world.
4 IDN
POL
MEX The ideal condition for emerging-market fixed-income valuations
PER
2 PHL
MYS ISR would be a continued slow recovery in the developed world. In
0
CHN KOR such an environment, we would expect emerging-market debt
0 1 2 3 4 5 spreads to fall moderately. In our view, local currency bonds can
IMF 5-year Average Inflation Difference Forecast
sustain their high running carry, as low developed-market growth
Source: Barclays Capital EM Strategy (“Local versus external under a ‘new should limit the amount of inflation that is exported to the emerg-
norm,’” 25 October 2010)
ing markets.
Investment Focus 8
With interest rate increases already priced into many local curves Regarding the fiscal/monetary policy risks in China, thus far, the
over the next 12 months, we believe there is room for investors authorities have deftly managed to engineer a gradual slowdown
to realize the high carry of local rates in spite of positive growth of their economy with little collateral damage to other markets.
fundamentals. In this slow-recovery scenario, local currencies will Any more aggressive measures could trigger a bout of risk aversion
likely continue their appreciating trend versus the U.S. dollar due throughout global markets.
to prolonged monetary easing in the United States and Japan, high
Also, as mentioned above, within the developed world, a quick
growth rate differentials with the developed world, and rising com-
move into a double-dip recession or much more rapid growth
modity prices due to supply/demand imbalances.
would be negative for emerging-market assets. In particular, a
Analyzing various local currency markets on a bottom-up basis, severe double-dip recession would likely cause a flight to safety,
there are select opportunities for further appreciation of emerging- and money flowing out of emerging-market assets, thus putting
market currencies, in our view, thus generating potentially positive pressure on prices.
total local market returns in emerging markets.
Summary
Risks
Overall, we remain bullish on emerging market debt. The gradual
In our view, the largest long-term risks for emerging-market debt
growth scenario in the developed world is quite constructive for
are: rising inflation; abrupt fiscal or monetary measures by the
emerging market valuations, as it is strong enough to maintain high
Chinese authorities intended to temper rapacious growth and
fundamental economic difference between the two markets, yet
inflationary pressures; rapidly rising or falling growth rates in the
not large enough to cause inflationary concerns.
developed world; potential complacency of EM policy makers;
and ad hoc capital controls. Continued inflows into emerging mar- While we are cognizant of the strong recent returns across emerg-
kets and potential complacency by fiscal authorities could lead to ing-market debt assets, we believe that both external and local
lower primary surpluses and inefficient spending. It is important debt remain undervalued in the current environment.
for emerging-market sovereigns to maintain fiscal discipline, espe-
cially in the wake of higher revenues from rising commodity prices.
Rising long-term inflation expectations have historically been the
Achilles’ heel of many emerging-market sovereigns, as inflation
becomes very difficult to control with imperfect monetary tools.
Important Information
Originally Published 19 January 2011. Revised and republished on 1 February 2011.
The strategies invest primarily in emerging market debt positions. The strategies will generally invest in debt investments denominated in emerging market currencies. As such, an
investment in the strategies is subject to the general risks associated with fixed income investing, such as interest rate risk and credit risk, as well as the risks associated with emerging
markets investments, including currency fluctuation, devaluation and confiscatory taxation. The strategies may use derivative instruments that are subject to counterparty risk.
Investments in global currencies are subject to the general risks associated with fixed income investing, such as interest rate risk, as well as the risks associated with non-domestic
investments, which include, but are not limited to, currency fluctuation, devaluation and confiscatory taxation. Furthermore, certain investment techniques required to access certain
emerging markets currencies, such as swaps, forwards, structured notes, and loans of portfolio securities, involve risk that the counterparty to such instruments or transactions will
become insolvent or otherwise default on its obligation to perform as agreed. In the event of such default, an investor may have limited recourse against the counterparty and may
experience delays in recovery or loss.
The strategies will invest in securities of non-U.S. companies, which trade on non-U.S. exchanges. These investments, which are denominated or traded in currencies other than
U.S. dollars, involve certain considerations not typically associated with investments in U.S. issuers or securities denominated or traded in U.S. dollars. There may be less publicly
available information about issuers in non-U.S. countries that may not be subject to uniform accounting, auditing, and financial reporting standards and other disclosure requirements
comparable to those applicable to U.S. issuers.
All index data is shown for illustrative purposes only and is not intended to reflect the performance of any product or strategy managed by Lazard.
The information and opinions presented does not constitute investment advice and has been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no
representation as to their accuracy or completeness. All opinions and estimates expressed herein are subject to change.
Past performance is not a reliable indicator of future results.
© 2011 Lazard Asset Management LLC