Sometimes we make the right investment calls for the wrong reasons. A couple of years ago, I suggested that Asian local currency government debt looked attractive. And that view played out even better than I hoped.
Had you bought the ABF Pan Asia Bond Index Fund, a broad-based Hong Kong-listed ETF, at the start of 2010, you would have made 30-35% including dividends and currency appreciation. Returns on higher-yielding debt from some individual countries have been two-three times that.
Those are pretty decent returns from bonds. Too decent in fact. For quite a while, I’ve been warning that emerging market debt had run ahead of the fundamentals. And in the last few days, a big sell-off in Indonesia has demonstrated that only too well…
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Foreign investors are driving this market
I originally had several arguments in favour of emerging market (EM) debt. One was that over time emerging markets would get to grips with inflation, while the West would see higher inflation due to loose monetary policy. This would be a reversal of the traditional pattern and lead to a lower inflation premium in EMs.
This definitely hasn’t worked out. Inflation may be high in some developed countries such as the UK, but it remains high in most EMs as well.
But that’s not a huge problem. This was a longer-term argument and I still think it’s very likely that the West is heading for an inflation problem in the years ahead, while EMs can avoid it if they take the right action.
Another assumption I made was that EM local currency debt markets would become deeper and more liquid as a result of a bigger pool of local institutions and other investors.
This hasn’t worked out either – and that’s more worrying. Take a look at the chart below from UBS. This shows the inflows of foreign money and the percentage of debt held by foreign investors for six popular markets (Indonesia, Korea, Malaysia, Mexico, Poland and Turkey).
As you can see, foreign holdings are at record highs. So what’s the problem with this? It looks, surely, like local currency debt is becoming more of an international asset class. And isn’t that what we want?
Well, no. Foreign money is often hot money – it can flow in and out on a whim. It’s good to see assets being held more widely. But we also want to see the growth of local institutional investors, who act as a stabilising influence on the market.
That is happening slowly in many countries. But it’s foreign flows that have driven the boom.
Even worse, those foreign flows may be a relatively shallow pool. There are relatively few major EM local currency debt investors and individual institutions that can hold a relatively large percentage of a given country’s debt. If one institution needs to sell in large amounts, it can have a serious impact on some markets.
Emerging market debt is not a safe haven
The third reason I liked EM debt was that many emerging markets would be recognised as better quality credits than they were before. They would then trade on lower yields, boosting bond prices.
Superficially, this has happened. We’ve heard a lot of talk about how EMs are better placed these days. I often say it myself.
But I don’t think that is what’s been driving the market. It probably accounted for many of the gains before the crisis, when EM debt was a lower profile but strongly performing asset. Today, it feels more like this is a justification for the real reason that ever more investors have been buying into these bonds.
That brings us to the fourth and final bullish factor for EM debt. Foreign investors were going to buy it for the yield. With US, UK and good quality Euro debt yielding 2.5-3.5% on ten-year government bonds, the 10% available on Indonesia was going to look pretty attractive.
And that’s exactly what has happened. Investors have rushed into EM debt on the basis of higher yields plus currency appreciation.
There’s nothing wrong with this as one part of the investment case. But it’s worrying if blindly groping for yield is the main driver behind the EM debt bull market. And it’s doubly worrying if investors deny that this is what they are doing by instead using higher quality and better liquidity as their cover story.
Unfortunately, that appears to be what’s happening. About a month ago, I was at an EM panel discussion featuring three experienced fund managers. Two were in EM equity and I found them surprisingly cautious and balanced given where they worked.
The third was at one of the major investors in EM debt. His presentation was interesting but glib, skating over risks and making a number of overblown claims about liquidity, market size and quality. At no point did he admit the obvious: the money coming into his firm was thinking about yield first and foremost.
And you can hear this a lot. The latest meme has it that EMs are the new safe haven – safer than the US. This is blatantly not true.
I believe EM prospects are better than the West and they will make a better long-term investment (although the Euro panic is starting to throw up attractive opportunities there and good quality companies are fairly priced in the US). But this is not the same thing as being a safe haven.
Indeed, almost by definition a true safe haven is a rotten investment. It’s where people rush when they are fearful and the return of capital completely dominates the return on capital.
That’s why short-term US bonds have on occasion had a negative yield in the last few years. Investors can be willing to accept a guaranteed loss of 0.1% to be sure of nothing worse.
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Buy equity or FX instead
That clearly does not describe EMs. And hence lately we have seen a rush back to the US and an unwinding of some of those supposedly safe yet high-yielding EM positions.
Indonesian ten-year bonds have seen yields shoot from about 6.5% to about 7.5% in a matter of days. There’s been similar action in longer-dated Brazilian bonds.
Obviously, this is not the end of the world. We’ve seen shake outs like this before. Even if we ignore the frantic selling during the global crisis, the Indonesian ten-year bond moved a similar amount at the start of 2011.
But this should disabuse investors of the idea that the world has yet turned on its head. There is a fair chance that at some point the US dollar will be a junk currency if America continues to follow its current policies. But we’re not there yet. It is still proving to be the safe haven when fear gets too high.
EM investors need to recognise that they are taking on risk in the hope of reward and not delude themselves with talk about safe havens. They need to expect volatility – and if they can’t ride it out, they probably shouldn’t be in these assets.
And at these levels, I don’t think the risk/reward ratio is right in the longer-dated EM debt that investors have rushed into. If you’re taking risk, you might as well be in equity. Sentiment has been pretty upbeat on Indonesia for a while and now that it’s souring, stocks are taking a hit as well as debt. The Jakarta Composite is off 15% since early September (see chart below).
It’s now on a price/earnings ratio of about 13-14 times. I’m not convinced it’s as cheap as that looks because margins are probably approaching a cyclical high. It looks more expensive on a price/book basis relative to history, as discussed last week: The cheapest markets in Asia.
And investors need to be mindful about the effect that cheap debt can have on equities. Firms grow used to being able to borrow at lower rates, gear up and then find themselves in trouble when that’s no longer possible.
But Indonesian shares certainly look more attractive than Indonesian government bonds if bought through funds that focus on well-run companies (the US-listed Aberdeen Indonesia Fund (US:IF) is one possibility). And readers with the ability to invest directly in Indonesia could certainly find specific companies to buy after the recent sell-off.
For example, pharmaceutical, healthcare and nutrition firm Kalbe Farma (KLBF:IJ) is down almost 25%. This is a good-quality business with minimal debt, mid-twenties return on equity and a 2.5% dividend yield. It may not look cheap on a p/e of around 19, but this is exactly the sort of branded consumer goods business that can earn excess returns over a long period of time and is worth paying a premium for.
Alternatively, there is still a good investment case for many EM currencies. If policymakers are going to keep inflation under control, they will need to let these appreciate over time.
Ideally, you could do this by opening foreign currency accounts. But for a basket approach, you could look at a bond fund that is as near to cash as possible, such as the Aberdeen Global Asian Local Currency Short Duration Bond Fund.
This might not be completely immune to wobbles in the bond market. But it holds shorter maturity and more liquid bonds and consequently should be much less affected by liquidity and inflation issues.
The FX theme doesn’t have the same potential returns that shares do. But the risk/reward payout is more balanced than with longer-dated bonds. Meanwhile, holding cash in the same currencies in which you intend to invest means that you are in position to deploy it into the stock market during sell-offs in the hope of good returns on the rebound.
This kind of flexibility is where investment safety comes from. Not long-term bonds at record low interest rates and few locals ready to step in when you want to sell in a hurry. That’s a big risk to take for just a bit more yield than you’d get at home.
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