The September 11 terrorist attacks in the United States spelled further adversity for emerging markets. The assault created “a short-term negative for emerging markets,” says Mohamed El-Erian, manager of the PIMCO Emerging Markets Bond Fund. “It’s going to push into fast forward the concerns we had about emerging countries.”
The bulk of those concerns are focused on Argentina, which El-Erian says is one of those higher-risk countries that “will come under renewed pressure because of weaker domestic conditions and the more difficult external environment.”
El-Erian recommends that advisors looking to dabble in emerging markets steer clear of buying J.P. Morgan’s Emerging Markets Bond Index Plus (EMBI+), the benchmark index for emerging markets bonds, because “20% of the index is Argentina.” Most investment managers use the EMBI+ for performance comparisons, and according to Offitbank’s most recent emerging markets research paper, the quandary in such widespread use of the EMBI+ is that “it does not come close to accurately representing the emerging markets bond universe.” In its research paper, Offitbank, the wealth management bank owned by Wachovia, argues that this “shortcoming is especially relevant given current concern about the possibility of default by Argentina, the most overweighted country in the index.”
PIMCO’s El-Erian says the EMBI+ index was up 3.9% at the end of August, but Argentina was down 18.4%. “If you take away Argentina, you get a very solid performance.” By avoiding Argentina, El-Erian says his Emerging Markets Bond Fund is up 17.6% year-to-date, and is the best performing bond fund according to Morningstar. “The difference is not only what you buy, but what you avoid buying,” he says.
Now is the time for advisors to buy good quality emerging markets bonds, El-Erian says. “If advisors are not buying the index, but are looking at individual components, then we think there is value in emerging markets.” He says the terrorist attacks “reinforce the argument that quality has to be the leading guideline at this point.”
The attacks have also exacerbated the “synchronized slowdown in the global economy,” El-Erian notes, which ultimately will cause consumers’ global risk appetite to wane.
Robert Kowit, who heads Federated’s International Fixed-Income Group, says he believes the risk of default in emerging market countries is overblown. “There are several misconceptions about emerging markets,” the Federated senior VP says. “The U.S. has high levels of defaults [in the high-yield market], with a concentration in telecom but active across the board. But defaults in the emerging markets are rare.” He points to 1999, when Mexico, Russia, and Brazil suffered currency devaluations, but Russia was the only one of the three to actually default. He says the real headline crisis at that time was volatility in price movements rather than default. While volatility has been high, especially in traditionally more volatile equity asset classes, the volatility has been diminishing over the past three years because of “the average quality of emerging markets” debt, at least as measured by the ratings agencies.
In the last 12 to 18 months, Kowit says, there have been defaults in emerging markets, but the countries where those defaults occurred “seem to have learned some kind of lesson and have done reforms, which is critical.” He says the quality of the countries’ debt has improved as well as the quality of investors. “Three or four years ago, emerging markets was dominated by hedge funds and now the large components are investment-grade bond accounts,” he explains. “This type of investor is not a junk bond investor but investment grade buyers, and they are not prone to trade on short-term moves.” He also says that the correlation between emerging markets debt and U.S. high-yield debt is “fairly low.”
“For a yield-oriented investor, a combination of high yield and emerging markets does make some sense,” Kowit says. “We have had portfolios for institutions where we’ve run 50-50 [on high yield and emerging markets], which has done pretty well.” With the volatility of emerging markets, Kowit says, advisors should allocate 10% to 25% of high-risk-tolerance clients’ portfolios to emerging markets.