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Emerging opportunities

Over the past couple decades, the source of international financial crises has swung like a pendulum from emerging markets to developed ones.

Over the past couple decades, the source of international financial crises has swung like a pendulum from emerging markets to developed ones.

Beginning with the Mexican peso crisis in 1994, followed by East Asia in 1997, Russia in 1998 and then Argentina at the turn of the millennium, emerging market economies had a sustained run of high-profile financial mismanagement.

More recently, starting with the 2001 bursting of the dotcom bubble, Western economies have stepped into the spotlight, stealing the show with the global financial crisis of 2007-08.  

Over the same period, investor appetite for government debt – from both emerging markets and developed ones – has likewise waxed and waned, typically in line with perceived risk (in the former instance) and interest rates (in the latter).

Unsurprisingly, given that the US Federal Reserve benchmark short-term rate has been near zero since late 2008, sales of Treasury bills have remained muted for the past several years. At the same time, the European sovereign debt crisis rendered government bond sales here even less attractive.

Despite pockets of recent instability in countries like Ukraine and Turkey, emerging markets are today generally seen as less risky than in earlier years. As well, while emerging market growth rates have not recovered to pre-crisis peaks, they still generally outpace developed markets.

The stage is therefore now set for emerging market bonds as an attractive opportunity for investors seeking portfolio diversification. Indeed, nine of the 10 best-performing emerging market funds in the year to date have at least some bond exposure.

A host of factors have aligned to bring an end to 10 years of consolidation, which left emerging markets struggling to attract foreign investors and foreign export demand, and boosting interest rates to stave off inflation.

Today, however, emerging markets – with manageable government debt levels, lower than in many developed countries – offer a middle-road investment path, in an environment known for its extremes, where the risk-reward ratio is favorable. High levels of private debt will seal the deal in pulling investors towards bonds.

Central banks in a number of developing countries have shown their willingness to counter inflation – which is partly due to the large decrease in exchange rates over the past few months – with contractionary policies. Expected returns on emerging market bonds will be significantly higher than those of government and high-yield bonds in developed markets.

Hard currency emerging market bonds provide a second level of protection, allowing investors to avoid the risks associated with local currencies, such as devaluations necessary to restore current account balances.  
Another factor contributing to a shift towards emerging markets is the so-called “demographic dividend”: with young populations and high growth rates, emerging markets are already home to more than 80% of the global population. Between now and 2025, another billion people will be born – almost all of them in emerging markets.

Abundant natural resources, including about 90% of proven global oil reserves, are an additional driver of long-term expansion, including ever-increasing South-South trade.

Not all emerging markets are created equal, however. Latin America, with its proximity to the US and high yields, will benefit early from foreign interest in sovereign debt – interest that will not yet be coming from Europe.

Insignificant current account deficits (vs. foreign currency reserves) and the ample liquidity available in the region make the risk-reward ratio more attractive than in cross-over and high-yield debt markets.

Emerging market borrowers – including both sovereign and corporate issuers – raised just over $100 billion of debt in the first quarter of this year, slightly below the total during the same period in 2013. There is every reason to believe, however, that as investors continue the search for yield, they will increasingly turn to emerging market bonds.

Mr. Doran is Chief Strategist at Brown Shipley, a UK-based member of KBL European Private Bankers. The statements and views expressed in this document are those of the author as of the date of this article and are subject to change. This article is also of a general nature and does not constitute legal, accounting, tax or investment advice.