GMO March 2017 white paper titled, “The What-Why-When-How Guide to Owning Emerging Country Debt”
As GMO enters its 23rd year managing emerging debt portfolios, we offer our perspectives on the frequently asked questions that have come up over the years, including:
- What are the characteristics of external, local, and corporate emerging debt?
- Why and when should one own emerging debt, considering diversification, alpha, and value?
- How should one own emerging debt? Dedicated external, local, corporate, or blended? Active or passive?
What are the characteristics of external, local, and corporate emerging debt?
Emerging debt has evolved as a concept over the last 30 years. In the late 1980s, the asset class got its start when western banks securitized defaulted sovereign bank loans into tradable “Brady bonds.” Over the years, the countries have refinanced these issues into external debt (debt issued in foreign currency) and/or local currency debt (debt issued in their own currencies), while corporates domiciled in these countries have issued corporate debt, mostly in foreign currency.
The graphs in Exhibit 1 depict the yields and the transactions costs (indicative bid-offer spreads on the bonds) associated with the three main benchmarks for the sub-asset classes. The inset exposures table shows the principal macro exposures associated with each type (e.g., “what exposures am I taking to get those yields?”). Appendix 1 discusses language for the risks of each type with more detail, particularly on liquidity risk. The transactions cost graph partially answers the question: “what is the indicative cost to replicate the exposures in the benchmark” assuming “normal” transaction sizes and no market impact? The main conclusions: the bundle of macro exposures varies across type, and the replication costs are high normally and sometimes, around crises, very high.
External debt (USD Sovereign and Quasi-Sovereign)
External bonds are represented by the J.P. Morgan Emerging Markets Bond Index Global (EMBIG), which includes sovereign issues as well as those sub-sovereign and corporate issues that are either 100% government guaranteed or where the issuer is 100% federal government owned. The main EMBIG index is restricted to U.S. dollar issues settled in Euroclear, although J.P. Morgan also produces a euro-denominated benchmark separately. For EMBIG, the exposures table in Exhibit 1 highlights the two principal exposures of the class: sovereign default risk and U.S. dollar interest-rate risk. The weighted average rating is Ba1/BB+/BB+ from Moody’s/S&P/Fitch, and the U.S. interest-rate duration is 6.7. The weighted average price bid-offer is around 80 bps, or just shy of 40x that of an on-the- run U.S. Treasury issue. Note that J.P. Morgan also publishes a “diversified” version of the index (EMBIG-D), in which larger issuers are capped, although the beta of the two is close to one. Each has 65 countries representing 142 issuers. Lately, EMBIG-D has overtaken EMBIG in terms of assets tracking it, according to J.P. Morgan.
Local currency debt (Sovereign)
Nominal1 local currency bonds are represented by the J.P. Morgan GBI-EM family of indices (broad, global, narrow), of which the “global diversified” (GBI-EMGD) is the most widely used. As the benchmark currently only captures 15 countries, some of which are large issuers, investors prefer the capped issuer diversified version. Local currency bonds are bonds issued in the country’s own currency, regardless of whether such a bond is issued and settled locally under local law or in “global” format under foreign law settling in Euroclear. In the first case, the investor first sells his home currency, buys the local currency of the country in question, and then buys the bonds, reversing the process on exit. In the latter case, all transactions (purchase, sale, coupon, and principal payments) settle in U.S. dollars at a “fixing” exchange rate (generally near the current spot rate). In the first case the investor takes cross-border exposure (the risk that upon exit capital outflow restrictions may exist); in the latter case the investor takes sovereign default exposure (the risk that the country may not be able to deliver U.S. dollars). As both are types of sovereign exposure, we view local debt instruments (from a foreigner’s perspective) as having sovereign default risk (GBI-EMGD rating is Baa2/BBB/ BBB). Furthermore, local debt instruments carry local interest-rate exposure (duration is 4.9) and currency exposure. The weighted average price bid-offer including the FX is around 50 bps. Barclays produces a broader index that includes 19 countries (capturing some more developed countries like Korea, Singapore, Israel, and Czech Republic). Given the country composition difference, the beta of the J.P. Morgan index has been 1.14 with respect to the Barclays index, and since 2013 the J.P. Morgan index has underperformed the Barclays index by a cumulative 7.4%.
Emerging corporate bonds are represented by the J.P. Morgan CEMBI family of indices (with broad/narrow and diversified/undiversified variants). The CEMBI Broad Diversified (CEMBIB-D) is the most widely followed. It is a USD-denominated index of bonds issued by corporates domiciled in emerging countries. Interestingly, J.P. Morgan departs from its EMBIG/GBI-EM method for defining “emerging countries” in this context, adopting a regional-based approach instead. In CEMBIB-D’s case, companies headquartered in Latin America, Eastern Europe, Middle East, Africa, or Asia ex-Japan are considered eligible, as are those with 100% of their operations there (as long as the bonds are guaranteed by the local operation). 100% government-owned quasi-sovereigns eligible for EMBIG are specifically excluded, but partially government-owned quasi-sovereigns make up about 30% of CEMBIB-D. A company can migrate from one index to the other based on nationalizations/privatizations. CEMBIB-D contains issues from 51 countries spanning A1/A-rated Qatar and Taiwan to unrated Iraq. The average rating is currently Baa3/BBB-/BBB. Given that the corporates are domiciled in emerging countries that have sovereign default risk themselves to greater or lesser extents, we expect such issuers to pay a spread premium over and above the sovereign’s own credit spread to account for their idiosyncratic risks. As the issues are in U.S. dollars, they also carry U.S. interest-rate risk. The issues contained in CEMBI are generally also included in the widely followed global corporate indices provided by Barclays/Bloomberg, with investment-grade issues included in the Global Aggregate and sub-investment-grade issues in the Global High Yield.
Exhibit 2 details some other attributes of the benchmarks as well as the MSCI Emerging Markets index (MSCI-EM), the emerging equities benchmark, for reference. After all, emerging debt often competes with emerging equities for risk assets.
Based on the table, we observe:
- For all classes of emerging debt, the fraction covered by the relevant benchmarks is much smaller than for equities. This suggests that there are more opportunities for alpha by taking off-benchmark exposure in debt than in equity.
- The local currency sovereign debt universe is 5.8x the size of external sovereign debt, but the index-captured fraction is much smaller in local debt. This is due to the relatively low fraction of the universe captured by the local debt index.2 The most widely followed local debt benchmark has a market capitalization that is 1.6x that of the most widely followed external debt benchmark.
- In external debt, there are two benchmarks with significant assets tracking them, while among the local debt and corporate debt varieties, one benchmark has become dominant. Exhibit 3 details the differences between the two