Emerging market bonds on the rise

The higher the yield, the higher the risk. This is, and always will be, an investment maxim you ignore at your peril. Just ask anyone who recently bought shares in insurers RSA Insurance Group or Aviva, for example, lured by what turned out to be a mirage of maintained dividends.

It is said that investment fashions come and go, but general truths endure. However, perceived wisdom is being cast aside as more and more investors face up to the reality of relentless economic progress in the developing world - and dangerous leverage in the developed.

Yet there is a strong perception that the lending of money to developing countries, in the form of investment bonds, is not a good game to be in. Memories linger of the great 1997-98 financial crash in Asia, the defaults of Mexico in 1982, Argentina and Uruguay in 2002, and of the rouble crisis in 1998, when Russia defaulted on internal debt and took its time to meet its obligations in the eurobond markets.

These have been the headline grabbers. The plight of smaller nations - tiny Grenada, for example, which in March said it could not meet its debt obligations - go largely unnoticed.

Suddenly, however, global bond markets, especially those for corporate debt, are having a nasty attack of the jitters. A glance in the rearview mirror indicates that, whatever politicians might say, inflation is the only way out for heavily indebted Western countries such as the UK and the US. Meanwhile, the recent and remarkable global re-rating of equities reflects more than just a hunger for yield; inflation, on the way up, is more destructive to bond than equity markets.

Moreover, real returns on UK and US government debt are in negative territory. Sometime there will be a return to positive real returns. This will cause a price rout.

However, one source of above-average returns is being largely overlooked: the government debt market of emerging countries. This is not a flourishing investment area, but a fund from one of the early fund managers in the market, Baillie Gifford, offers a yield of almost 6%.

The Baillie Gifford Emerging Markets Bond fund has interests mainly in the bonds issued by countries in Africa, Asia and emerging "Europe" (primarily, Russia, Poland and Turkey), which collectively account for some 40% of the fund. The emerging markets bond sector may be a backwater, but the Baillie Gifford team is the one buying the drams of a Friday. Between the end of January and early March, the fund rose in value from £360 million to almost £500 million.

Bonds held are issued in the currency of the borrower. "We believe bonds issued in local currencies are a stronger asset class than bonds issued in hard currency," says Sally Greig, co-manager of the fund. "Also default risks are lower. Countries issuing bonds in their own currencies is a sign of maturity and stability."

She points out that the Asian crisis of 1997-98 was brought on by countries that had borrowed in US dollars. "It is difficult to default if you are in charge of the printing presses, which a recent problem country, Greece, is not."

Essentially, Greig's fund is a high-yield fund with side bets on currencies. The performance of the fund - up by some 66% since launch in September 2008 - has been helped by currency appreciation and interest rate falls.

"We have taken currency risks and luckily they have worked out for us. We don't have a hedging policy," Greig says. But derivatives can be used to manage unwanted risks, as when Greig likes a country's bonds, but not its currency. Some of its holdings are inflation-linked - holdings in Brazil, Turkey and South Africa, for example - but investments are largely orthodox bonds and tend towards longer durations.

Cultural understanding

Greig and her six colleagues do not sit in Edinburgh poring over data and spreadsheets. "It is important to go to these countries, walk the streets and get a sense of the place from its people; talk to taxi drivers, people on building sites; try to understand the history and culture.

"We meet ministers of finance, the central banks and politicians for the official line. Then we talk to other people: journalists, asset managers, the IMF, to try to build up a picture," she says.

Understanding a country such as Russia takes time. Greig says people think Russia "is just an oil story". However, she reveals: "We are overweight Russia and the rouble, and we think the market is missing some positive aspects." The country is lessening its dependence on oil, and reform of the bond market settlement process is taken as a sign of market liberalisation.

She says Russia's small public sector has little debt, so the government does not really need to borrow abroad, but "the oil sector needs investment" and Russia's admission to the World Trade Organisation will increase the need for investment capital.

The Soviet Union's former captive, Poland, "has always held itself up as the great success story of eastern Europe, and the country didn't suffer too badly from the financial crisis", she says. "But growth is slowing down more than the market expects. Savings were drawn down to fund all that consumption. Now that some of that power has gone, inflation will fall off." She expects a cut in interest rates of some 0.5%. The prospect of the country joining the euro "is some way off".

Turkey, as any UK visitor to the country can attest, is a land of relentlessly rising prices. "Inflation has always been Turkey's bugbear and it hasn't got it under control." Some 10% of Greig's fund is invested in Turkey. All the holdings are index-linked.

"South Africa is similar," she says, but further north the fund has dipped its toes into Nigeria. She admits the fund could well dabble more in what are known as frontier markets. Nigeria was recently added to the index her fund follows: the JPMorgan GBI-EM Global Diversified index, unhedged in sterling.

"Nigeria is a small part of the index, but the situation there is interesting," she says. Africa has some of the world's fastest-growing economies, so it wouldn't be surprising if other African countries follow Nigeria's path. The leading candidate is probably Ghana. Nearer home, a recent recruit to the index is Romania, where Greig's fund has a small presence.

Greig also has a modest stake in Thailand, the Asian country arguably most affected by the 1997-98 crisis but now thriving. She says: "Thailand has grown strongly and interest rates are low. But the economy is growing by 6% a year and inflationary pressures are starting to build. Indonesia is a similar story, and inflationary pressures will build there as the country eases subsidies on rice and so on."

The fund is overweight in South America, principally Mexico, but also Peru, Colombia and Chile. Greig's largest holding in the region, via index-linked bonds, is in Brazil, where economic growth has now slowed dramatically.

"Brazil has cut interest rates a lot," she says. But expectation that interest rates will rise by some 3% over the next few years "is not realistic, given the state of the global economy. They will rise, but not by as much as expected".

Greig says emerging countries' bonds, in the context of institutional portfolios, are an "under-allocated asset class, less than 2%, partly because of past default crises". She adds: "[A crisis] could happen again, but the big difference now is that bonds are in local currencies."

The biggest risk? "I worry that emerging market policies will mimic those of developed markets - the printing of money and loose monetary policy. And these emerging countries will not like the impact of currency wars [such as those underway in the UK, Japan and the US]. They will suffer because of the strength of their currencies".

However, she adds: "The positive is that developing markets did not fall back into severe recession in the global crisis." If they are overcome in the aftermath, "they will bumble along with low growth, helped by inflows of liquidity to help their economies grow and build infrastructure".