For Professional Clients only

Reasons to invest in global emerging markets debt

October 2012

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Reasons to invest in emerging markets debt?

There has been a significant evolution in emerging markets debt over the past fifteen years, with the asset class benefitting from structural macro economic improvements and an expanding investor base. The move away from fixed exchange rates coupled with increased foreign exchange reserves and more disciplined fiscal and monetary policies have contributed to improved fundamentals among many emerging market countries across Latin America, Eastern Europe and Asia. As a result of these improving fundamentals, numerous emerging markets have had their credit ratings upgraded. Investors may be surprised to hear that over half of emerging markets now carry investment grade ratings. With government bond yields at historic lows in many developed markets, investors are looking further afield to fulfil their income requirements. Because of their improving risk profile and stronger fundamentals when compared with developed markets, emerging markets bonds are increasingly coming under the spotlight.

dependent on developed economies and their overall expected growth rates are much higher than for developed markets. For these reasons, emerging markets could continue to outperform developed markets on a structural basis as long as policy makers continue to employ sound macroeconomic policies. These improving fundamentals as well as low financing needs provide emerging market countries more policy flexibility than developed markets, thus increasing the potential for their economies to continue growing at a faster rate.

…reflected in credit ratings

While developed market ratings have steadily fallen since 2009, emerging markets ratings have continued to rise. The relative change in credit ratings reflects the improving fundamentals of emerging market countries, namely stable debt levels, current account surpluses, controlled inflation, and tighter monetary policies. Recently, while many European countries have been downgraded, the investment world has witnessed a significant number of credit rating upgrades in emerging market sovereigns and corporates, including those of Brazil, Peru, and Panama. Over 45 emerging market countries are now rated investment grade, equating to over 50% of the universe. We expect emerging market sovereign upgrades to continue to exceed downgrades. The better credit quality that many emerging market sovereigns have been able to achieve should provide some level of comfort to those investors who are looking at the asset class for the first time.

Local emerging market currencies are also part of the key to the outperformance of emerging market bonds, as one of the attractions of investing in local currency denominated bonds is that it is a play on currency appreciation. Many emerging market currencies are undervalued on a purchasing power parity basis and

Sound long-term story

The long-term case for emerging markets is now well known, but we believe it is worth reiterating in the context of the weaker growth opportunities currently offered by developed nations. Emerging market fundamentals, such as the debt / GDP ratio and current account balance, are significantly stronger than in developed markets. Many emerging market countries experienced financial crises in the 1990’s and early 2000’s stemming, in large part, from fixed exchange rates pegged to the US dollar. In response to these crises, emerging market countries implemented monetary policies that abandoned the currency pegs and allowed their currencies to float, adjusting to economic and market developments. This allowed these countries to accumulate substantial foreign currency reserves, and by 2008, the international reserves in many emerging market countries exceeded their foreign debt, thus positioning them as net creditors for the first time.

Now emerging market FX reserves are eight times larger than they were a decade ago and are nearly double the foreign exchange reserves of developed economies1. Their strong positions in external currencies allowed emerging market countries to implement countercyclical policies during the 2008 global financial crisis. Consequently, during the past three years as many areas of the world found themselves in the throes of a recession, emerging market economies have continued to grow and emerging market assets have increased their share of the global equity and bond universes.

Changing economic landscape…

Global emerging markets have continued to prove their resilience during the recent periods of stress in the developed world. Emerging markets have experienced increased decoupling and have become less

1 Source: IMF, JP Morgan, HSBC Global Asset Management as of April 2012.Any forecast where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management (France) accepts no liability for any failure to meet such forecast.

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Reasons to invest in emerging markets debt?

may appreciate over the long term as their higher interest rates will attract ‘carry trade’ flows, while rates in the developed world remain at very low levels. By the same token, many developed currencies look overvalued.

Expanding debt universe

The emerging market debt universe continues to grow and become an increasingly important component of fixed income markets. We expect continued expansion of the emerging market debt universe, with an estimated $53 billion in gross sovereign issuance and emerging market corporate issuance of $173 billion in 2012 alone. In addition, compared to previous years, the majority of this new issuance should come from investment grade issuers rather than high yield issuers, further supporting our view that fundamentals in the asset class continue to improve. Despite the high growth, the asset class still has a great deal of scope for expansion, particularly in the areas of local currency and corporate bonds. In addition, the so-called 'frontier markets' (i.e. less developed emerging markets) are steadily maturing. This means that investors are not chasing a fixed pool of assets, but an expanding opportunity set of sovereign, municipal, corporate and structured debt, providing investors with a range of choices from very high quality investment grade to high yield.

Past performance and diversification benefits

Investors who are already invested in these assets have been rewarded with strong returns. The benchmark index (JP Morgan EMBIG) has returned 10.7% since 2000, outperforming global bonds (JP Morgan Global Bonds index), which have returned 6.7% and global equities (MSCI World) which have returned -1.10%2.

In addition to providing income opportunities, an allocation to emerging market debt offers potential diversification benefits. Emerging market debt has low correlation to other asset classes, in part due to the fact that much of it is issued in local currency. While emerging market bonds and currencies performed more strongly than global bonds on an absolute basis since 2000, they have also experienced higher volatility. However, emerging markets have a lower correlation

with many traditional markets, meaning that small blends of EM into such portfolios would have had surprisingly positive effects. In fact, a 20% mix of EM hard and local currency bonds into some traditional bond allocations would have generated absolute and risk adjusted return improvements, as the table below demonstrates:

Comparative returns of bonds2

1st January 2000 – 30 June 2012

“Global” – JPM GABI; EM Local – JP Morgan ELMI+ Index; EM Ext – JPM EMBI Global

For illustrative purposes only, the performance figures displayed relate to the past and past performance should not be seen as an indicator of future returns.

The combination of higher coupons and diversification benefits makes the fundamental case for emerging market bonds very compelling in the current low- yielding environment. While they have often been perceived as riskier than the US and Europe, the current reality could be more balanced: many emerging countries have low debt levels and plenty of cash. Once thought of as peripheral and exotic, emerging market bonds warrant serious portfolio consideration as the fixed income landscape continues to evolve.

Any forecast where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management (France) accepts no liability for any failure to meet such forecast.

2 Annualised returns from January 2000 to June 2012 Source: Bloomberg

Cum. Returns (%)

Ann. Returns (%)

Risk (Std. dev. %)

Reward-to- Risk

100% Global Bonds

124.4 6.7 6.1 1.09

80% Global / 20% EM Bond Mix

138.3 7.2 5.9 1.21

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Important information

This document is intended for Professional Clients only and should not be distributed to or relied upon by Retail Clients.

The contents of this document may not be reproduced or further distributed to any person or entity, whether in whole or in part, for any purpose. All non-authorised reproduction or use of this document will be the responsibility of the user and may lead to legal proceedings. The material contained in this document is for general information purposes only and does not constitute advice or a recommendation to buy or sell investments. This document has no contractual value and is not by any means intended as a solicitation, nor a recommendation for the purchase or sale of any financial instrument in any jurisdiction in which such an offer is not lawful.

The views and opinions expressed herein are those of HSBC Global Asset Management at the time of preparation, are subject to change at any time. We accept no responsibility for the accuracy and/or completeness of any third party information obtained from sources we believe to be reliable but which have not been independently verified.

There are important differences in how the strategy is carried out in each investment vehicle. Investors should carefully consider the investment objectives, risks and fees of the strategy carefully before investing.

The value of investments and any income from them can go down as well as up and investors may not get back the amount originally invested. Where overseas investments are held the rate of currency exchange may also cause the value of such investments to fluctuate. Stockmarket investments should be viewed as a medium to long term investment and should be held for at least five years. Any performance information shown refers to the past and should not be seen as an indication of future returns.

Issued by HSBC Global Asset Management MENA, a unit that markets HSBC products in a sub-distributing capacity on a principal-to-principal basis, and is part of HSBC Bank Middle East Limited, PO Box 502601, Dubai, UAE, which is incorporated and regulated by the Jersey Financial Services Commission. HSBC Bank Middle East Limited is a member of the HSBC Group. © Copyright. HSBC Global Asset Management 2012. All Rights Reserved.