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Emerging market bonds still looking good

In light of the difficult circumstances surrounding the equity markets, investors are hunting around for alternatives. Unfortunately, savings-book interest rates are limited, as are the returns from safe developed-country government bonds...

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Nonetheless, any diversified portfolio worthy of the name will always be able to find alternatives … which should include emerging market bonds.

In the first place, we can see that the emerging countries are playing a more dominant role in the global economy with the passing years. Even though they have not yet reached their full economic capacity, they are already in a position to generate sustainable economic growth, to which the continuous improvement in their credit rating bears testimony: the average creditworthiness of the emerging countries has climbed to an impressive BBB- (EMBI Global Diversified Index), reducing even further their relatively low debt/GDP ratio. From this, we may conclude that this is a rising trend, supported by higher and sustainable economic growth and low interest rates.

In the second place, the emerging countries are benefiting from a whole series of other global trends. By the year 2050, the planet, will be home to no fewer than 9.5 people, most (86%) living in the developing world. We are also witnessing a substantial increase purchasing power in emerging countries. Estimates indicate that, circa 2030, there will be a 2.5 billion-strong middle class, with the number of households with annual earnings of more than USD 6000 doubling. All the more reason to conclude that the emerging markets are on their way to becoming the powerhouse of global consumption. Take, for example, the growth in the automobile industry in China, where, currently, there are something like 40 cars on the road: circa 2030, there will be more than three times as many (135 million).

Thirdly, valuation, following the rally of the past few years, is still attractive. Granted, emerging market bonds, although not as cheap as they used to be, still demonstrate considerable potential. The quality of these bonds has substantially grown whereas the quality of the so-called risk-free bonds has sunk (think US). Investors, seeking returns at all costs, will turn naturally to emerging countries debt instruments, where the difference in interest rates can be as high as 360 basis points. In addition, the spread is far removed from its historical low.

Debt instruments from the emerging countries in foreign currencies (USD) and in the local currency are both interesting. Foreign debt paper from the emerging countries could benefit from a further tightening of the spread, which is still even wider than it was in 2007 (minimum of 165 basis points in 2007, when the average index rating was no more than BB+). Local-currency bonds could, in addition, take advantage of the gradual appreciation of the emerging countries currencies, most of which remain undervalued and where, in consequence, there is still a great deal of room for manoeuvre as regards currency appreciation.

Ken Van Weyenberg , September 2011

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