September 1, 2010

The Evolving Emerging Markets Debt Asset Class

The emerging markets debt asset class has undergone a substantial transformation from its roots in the late 1970's. As a result, so have the strategies in which money managers employ. The increasing number of mutual funds and types of investment approaches presents new challenges for wealth managers in the area of manager selection, monitoring, and portfolio construction.

In the 1970's, the debt issued by developing countries was held in the form of direct loans by the large global banks. Following the Mexican Debt Crisis in 1982 and the subsequent introduction of the "Brady Plan," these governments began issuing U.S. dollar denominated debt, backed by U.S. Treasury issues. The emerging debt market continued to grow in fits and starts over the course of the 1990's, despite regular debt crises such as the Asian Contagion in 1997 and the Russian Debt Crisis in 1998. Since then, solid economic growth among the emerging countries has led to credit rating upgrades and broader and more liquid markets. This economic change has also fostered a much improved legal and regulatory environment, easing the flow of global capital.

Today the emerging debt market consists of three primary segments. The largest and most liquid portion of the market is made up of U.S. dollar-denominated sovereign bonds, which are direct obligations of the issuing nation, with principal and interest paid in dollars. The second- largest portion of the market is the local currency-denominated sovereign bonds, similar to the dollar denominated issues; these are direct obligations of the issuing government, but interest and principal is paid in the issuing country's own currency. The third-largest segment is corporate bonds that are issued primarily in U.S. dollars, but some are issued in local currencies. Mutual fund managers today primarily rely on these three main tools, but may also invest directly in foreign currencies either through derivatives, or short term deposits. The main goal of these funds is to capture the risk premiums, usually in the form of higher interest rates, associated with these emerging economies.

A majority of the mutual funds available to U.S. investors currently focus on the dollar-denominated sovereign bond market, as it offers the most liquid investment pool and gives investors exposure to the emerging market economies without the volatility associated with local currency debt. Although the emerging debt market tends to be less efficient overall, the dollar-denominated market represents the most efficient portion of the overall market.

The local currency market has been increasing in importance over the past decade as governments have been able to successfully access the global capital markets without the enticement of a dollar-denominated issue. This is important for the local governments in that it eases the planning and budgeting efforts, matching local currency income through various taxes and tariffs with the debt service payments. This has effectively transferred the currency risk, if any, from the issuer to the investors. Many of the U.S. based mutual funds will allocate a small portion of their assets, up to 20% for example, for these types of issues, but there are a growing number of funds that invest a majority of assets in the local currency sovereign issues. For these fund managers, the local currency aspect offers yet another source of potential excess return, but also introduces another significant risk variable into the portfolio. This type of investment requires a significantly larger skill set to correctly anticipate the impact of a wide variety of macroeconomic factors on each currency relative to the U.S. dollar. Indeed, these funds will tend to be managed using a macroeconomic, top-down process. Given that many have very short track records, advisors are forced to place special emphasis on evaluating the experience of the investment team and the resources of the firm to judge the manager's ability to implement this advanced skill set.

Finally, there are funds that look at each investment solely on the basis of the currency involved and subsequently invest primarily in currency specific derivative contracts and short term deposits. These funds offer investors the maximum diversification benefit relative to a standard investment portfolio, but also tend to have much higher volatilities and should be viewed as part of the risk assets of a portfolio, similar to commodities or equities, rather than part of the portfolio's fixed-income allocation.

The emerging markets debt space has become particularly attractive over the past year when compared to most of the developed economies. The impact of the financial crisis in 2008 and the large scale government stimulus spending in 2009 has led to the deterioration of the fiscal health of many developed economies. While the emerging economies were also impacted by the financial crisis, much of the emerging world has already returned to a relatively normal growth path, and continues to have sound and even improving fiscal conditions. What has been seen as "risky" and "safe" historically may need to be carefully revisited in light of the current global economy.

J. Gibson Watson III is president and CEO of Denver-based Prima Capital, which conducts objective research and due diligence on SMAs, mutual funds, ETFs and alternatives.

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