Every investment will attract those who extol the virtues of it, and those that don’t!

Often those who are most positive are those that have a means for investors to ‘benefit’ from the sector, and those that aren’t, don’t!!

For investors it is very difficult to wade through all the hyperbole to make an informed decision on whether an investment is good, or just headlines.

Emerging market debt (bonds) is an example of this.

The background….

The origins of emerging market debt goes back to the seventies where the oil crisis reversed the traditional flow of capital, as oil exporting nations began to accumulate vast wealth.

Their newfound wealth gave some of these emerging market countries the ability to borrow. However, the immaturity of these markets led to defaults and various debt crises followed.

In the late eighties a debt relief programme converted US bank loans into bonds. Since then the fixed interest universe has expanded and the market has become more liquid.

The Asian crisis of 1997 highlighted continued weaknesses within the economies and forced many countries to adopt a more disciplined approach to managing their fiscal and monetary policies. As a result many of these economies fared well during the crisis of 2008.

More recently local currency bonds have emerged to reflect the ability of some emerging market economies to withstand shocks from the global financial system.

However, emerging markets are often perceived as a holistic group – if one economy is bad then all are bad. With the taper talk in May 2013 there was a fear that the withdrawal of easy money would drag down all economies. In reality as with developed economies some are good and some are bad.

On the back of 2013 many argue that for the additional risk and volatility, there is little perceived gain from emerging market debt and therefore this is an asset class to be avoided. We’re not so sure…..

High risk, greater volatility, average returns

Some of the arguments against the asset class include:

Weakening currencies – this potentially increases defaults for dollar dominated bonds. As the dollar appreciates it means more local currency is needed to pay the coupon and therefore as the cost increases so does the potential for default. To counter this investors may opt for local currency bonds but as the currency depreciates so the return decreases.

Federal policy – quantitative easing is likely to come to an end by the end of the year. Emerging markets benefited from the flow of easy money and just the threat of it ending unsettled the markets in 2013. Although the markets are not expected to react in the same way it is likely that returns will be lower going forward.

Economic growth – economic growth across the regions is below expectations and if growth remains sluggish then there is unlikely to be much potential upside.

Inflation – rising inflation could force interest rate rises which in turn slows growth.

Rising supply – $94 billion of US dominated bonds are likely to be issued in 2014, with money coming out of the asset class it means potentially the demand is not there. Any over supply will squeeze potential returns.

With this in mind the biggest question is risk appetite. The ‘risk’ of the asset class appears much greater than developed market bonds with no real additional payback. Although interest rates will go up in the developed markets bond managers can make returns with less volatility and therefore the appetite to invest is not there.

Why bother…..

Every market has challenges however emerging markets should not be considered as an holistic group.

Investment Grade – 70% of emerging market debt is investment grade. Economies such as Malaysia, Poland, Chile and Mexico have highly rated investment grade debt whereas countries like Venezuela, Ukraine, Ghana and Argentina have high yields but are seen as distressed debt. Similar to the developed markets, not all the countries are the same and picking the right ones is a crucial part of choosing the right fund.

Fundamentals – it’s an age old argument for investing in emerging markets but it is true – 77% of the world’s population and 75% of the world’s land mass comes from these economies, these economies tend to have younger demographics, accumulated reserves and low debt burdens relative to GDP. A complete opposite to most developed economies.

Growth – growth is slower but it is expected to be around 4.9% in 2014 up from 4.7% in 2013. Significantly higher than developed economies! 2015 is expected to be higher as developed market growth flows through into emerging markets.

Homogenous – like developed economies not all emerging economies are the same, the market is starting to distinguish between the good and the bad. Good economies provide stability, manage debt, demonstrate strong growth and have sound fiscal policies.

The underlying point is that many developed economies have high debt relative to GDP, much lower growth, an aging population and interest rates heading in one direction. The fundamentals for growth on bonds from these economies is not good, and it is likely over the long term the reward from emerging markets will be greater.

Head change

The headwind is a strong argument not to invest in emerging market debt and fear drives investors. However, the arguments for are equally strong but care needs to be taken in choosing the right manager and a belief that the worse has been and the outlook is brighter.

One additional factor to consider is whether to choose local hard currency. There are arguments either way. Hard currency is considered less volatile as the currency risk rests with the issuer but local currency rests with the investor.

However, if the currency appreciates then the investor should over the long term benefit from local currency because it will add to the total return potential. However they are highly sensitive to global asset flows as we saw in 2013 with these funds suffering the greatest losses when compared to hard currency bonds.

Effectively investors need to weigh up whether the potential upside with local currency outweighs the potential downside risk.

The right fund

The space is not full of funds and the key is deciding what options an investor wants and how much risk they are prepared to take. For example, the Baillie Gifford Emerging Market Debt fund is a local currency offering with a concentrated portfolio of around 55 holdings. Some of its highest holdings are in Poland and Mexico which are some of the strongest emerging market economies. Its debt is mainly AAA and BBB rated.

As a contrast Threadneedle have a hard currency offering (they also have a local currency) and this has nearly 200 holdings. Its main focus is on BBB rated debt but it also has around 25% in BB and below debt. So it is taking greater risk on the debt but offsets that by a higher number of holdings. Although it has a high weighting to Mexico it also has a high weighting to Venezuela which is considered distressed debt.

These are not the only funds, Investec, Standard Life Investments and others offer these funds but we have used these as examples of polar opposites but within that they could potentially be a good blend.

Conclusion

However, you spin the dice there is no doubt that returns from developed market debt will be squeezed as interest rates rise. The wider dynamics of demographics, growth and debt lessen the attractiveness of the asset class. Whereas emerging market debt offers the opposite.

For investors they will need to consider whether the reward outweighs the risk.

NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.