Barclays Capital may not be too hot on some emerging-market credits (ahem, Hungary) but they certainly make a stirring case for EM bonds overall.
Or rather, they make a stirring case for the rise of emergification.
That’ll be a neologism for the attractions of EM bonds to institutional investors in their age-old quest for portfolio diversification. And this diversification via emergification trend looks like it could run and run.
Here’s the gist of BarCap’s recent note on local currency EM bonds (emphasis ours):
According to our EM FX forecasts against hard currencies (G3), there is much value left in local currency bonds, even at the long ends, and despite the rising inflation in EM. We expect the recent flow trend to remain, leading to more dislocations in the back end of local curves, as we look for global portfolios to pay a premium to diversify into local currency debt.
We measure value in local currency bond in various ways, but all under a rather simple approach. Broadly speaking, we compute spreads between local and USD sovereign yields and then compared them against measures of expectations of either inflation differential or EM FX depreciation against the USD. Inflation differential expectations provide an idea of the relative value of local bonds from the real rates perspective, while using FX depreciation expectations hints at whether local bonds are attractive once expected gains (or losses) from currency exposure are taken into account.
What BarCap find is that 10-year local currency bonds have outperformed their 5-year counterparts recently. Full details in the usual place, but it’s a phenomenon that’s been supported first of all by EM central banks fighting currency appreciation in the short term (longer-dated paper lets you bet on appreciation resuming later on).
Then again, there’s another factor holding up the long end of EM bonds — diversification/emergification. This is the key bit from BarCap:
Also, from a more structural standpoint, a growing demand for diversification is likely underway. First, consumers in the developed world may be questioning the capacity of the US dollar to hold its value beyond this cycle, given the long-term fiscal and growth concerns. Second, these consumers may be likely revising the perception that the developed world is immune to sovereign default, tilting portfolio exposure away from home. Third, the relative size of the developed world is quickly shrinking, implying that shocks in the EM world may have growing consequences for consumers in the developed world and raising the appetite for local EM bonds for hedging purposes.
And in fact, when you look at the really big picture, the supply of local currency bonds is a drop in the ocean compared to potential demand:
…total assets under management for global pension funds, mutual funds, insurance funds, sovereign wealth funds, private equity, hedge funds, ETFs and private wealth totaled USD119.3trn in 2009. The first three, considered conventional asset managers, amount to USD71.2trn…
If only 20% of these managed global portfolios are diversified away from the developed world under the “new norm,” then USD14.3trn should be allocated into EM. Yet the universe of investable bonds in Barclays Capital’s EM sovereign credit and local bond benchmark portfolios amount to only USD481bn and USD1.37trn, respectively. Furthermore, total outstanding international debt securities issued by emerging market countries (private and public) stood at USD1.05trn by end-Q2 10, according to BIS.
In short — a potentially huge tide of money, pursuing relatively few assets. Institutional investors are of course arising from emerging markets in their own right, too. That’ll create further demand for longer-dated EM bonds (while EM central banks will still be patrolling exchange rates) and there’s a strong hedging advantage inherent in EM bonds versus EM FX.
So look out for this one.
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Bubble trouble
Of course, look out for emerging market bubbles and/or risks to EM bond markets. BarCap’s note lists a legion of ‘em, including runaway inflation, a broad appreciation of the renminbi leading a wave of other appreciations, plus (interestingly enough) the creation of large renminbi bond market, which could really take off and affect the capital scarcity we’ve seen so far.
Interesting to note that on some of these risks (inflation, say), some are in fact looking to even more emergification via other EM bonds. Here’s Philip Poole of HSBC Global Asset Management, arguing in Morningstar for more EM inflation-linked bonds:
But there is no escaping the fact that inflation in the emerging world could also be the end result of this combination of the frantic search for yield coming from developed economies met by unsterilised currency intervention in the emerging world, aggravated by food inflation pressures and growing capacity constraints.
…So as well as remaining exposed to carry currencies, we believe that investors in emerging markets should buy some inflation protection via inflation-linked securities.
The race is on to diversify not just into but within EM debt — emergifying once more — elsewhere, in order to avoid bubble trouble.
FT Alphaville recently attended the emerging markets panel of a big CIO conference at which one of the speakers — the manager of one of the most innovative, if not the biggest, intergovernmental pension funds out there — extolled the virtues of EM convertible bonds for portfolio management. It was all about the convexity, he argued. To approving nods from his peers.
Like we said — one to watch. And looks like there’s no going back this time.
Related links:
Brazil, the clever currency warrior – FT Alphaville
The rush to EM – FT Alphaville
Of bond markets and imbalances – FT Alphaville