Local Currency Emerging Market Debt: a profitable way to educate fixed income investors about tomorrow’s world of risk
A year on from the demise of Lehman Brothers, the effective nationalization of AIG and the corralling of the free-running bull that was Merrill Lynch, we are only now beginning to grasp the enormity and historical significance of what has happened: we are in the twilight of the age when the United States essentially defined the foundation of risk. Henceforth the axis upon which this world will rotate will shift decisively Eastwards.
A year ago, financial markets were hit by the equivalent of a nuclear accident. The core of the power station of risk was damaged; the twin reactors upon which the calculation of global risk were traditionally based – the yield on the 10 year United States Treasury Bill (UST) and the numeraire of that yield, the US Dollar – both have visible cracks in them. Few believe that they can be restored to their status quo ante.
Yet when the meltdown hit financial markets a year ago, the reflex reaction by most global investors was a flight to the safety of US Dollar-denominated assets, especially Treasury Bills. Today, many investors realise that this sheep-like response actually increased their risk profiles; last year’s flows were often a “flight to danger”. Such investors now realise the phrase “the full faith and credit of the US Government” no longer carries with it the cast-iron sense of security that, a decade ago, ensured that the yield on the 10 year UST was effectively the mathematical definition of the “risk free rate”.
No longer: when Timothy Geithner, the US Treasury Secretary, tried to reassure the students of Beijing University that Chinese foreign exchange reserves deposited in US Dollar-denominated USTs were safe, he was met with laughter. His audience knew that, post 2008, the US Emperor’s New Clothes were, if not yet non-existent, increasingly threadbare. Today many in the global crowd – especially its increasingly influential Chinese section – are starting to notice Uncle Sam’s growing nakedness.
2009 has seen a rapid unwinding of 2008’s so-called “flight to safety”, that rapidity perhaps reflecting investors having realised that their behaviour last year was not so safe after all. It is as if pre-historic man sought refuge from a plains fire in a cave only to find that it was home to a sabre-toothed cat; 2009’s events suggest that investors “have again decided to take their chances with the fire”! One new employee at UBS naively yet insightfully dubbed this year’s outflow from USTs and the US Dollar as a “flight to risk”.
The phrase “risk-free rate” was always more rhetorical than precise: USTs were never without risk and neither was the US Dollar. What the last year did was expose the daylight between rhetoric and reality in the world of risk, a world which, until then, been framed by the United States. In so doing, it has qualified the bullet-proof credentials of the UST market and begun to undermine the US Dollar’s reserve currency status.
In this post-Lehman world, truly global investors – those not constrained by the woolly logic of home bias – are now asking hard questions. Are US Treasuries that safe after all? Even if one answers ‘yes’ because, in the decade ending 2008, they outperformed US equities, have they still been undone by their US Dollar denomination?
Given this backdrop, sophisticated global fixed income investors are broadening their investment horizons and, because of what happened elsewhere in the developed world over the past year, looking beyond the ‘usual suspects’ of Japan, the EuroZone countries and the UK.
This highlights the first reason why local currency Emerging Market Debt (EMD) is closer to becoming a fully-fledged mainstream fixed income option: the traditional options are damaged, perhaps irretrievably so. Indeed one can argue that those seeking both yield and the kicker that increasingly comes from currency appreciation are, when considering the EMD option, faced with the closest thing there is to a ‘must do’.
The big revelation dawning on many of these investors new to the pastures of EMD is that, upon closer examination, they can be ‘greener’ than those in developed countries: risk-adjusted returns can be higher because yields are higher and risks – measured by volatility – are lower.
The growing attraction of EMD is further supported by the extraordinary fiscal stimulus to which most democracies, be they Western or Japanese, have committed themselves. Their issuance pipeline is starting to weigh heavily on their bond markets’ prospects. Their central banks are also operating hyper-loose fiscal policies through historically low interest rates; they are unlikely to withdraw this accommodation soon. Combined, these ‘anti-bond’ fiscal and monetary policies of the developed world hardly offer an attractive backdrop for bond investors.
The second reason why EMD is becoming more mainstream within the fixed income universe is that emerging market economies are becoming more mainstream within the global economy.
This does not merely reflect the growing sizes of the Chinas and Indias. Many Emerging Markets, though by no means all, are better run than in the past, guided today by macroeconomic policies that are less inflationary and more growth oriented. This means many more EM governments run “bond friendly” policies than was the 1990s norm. Indeed, many Emerging Market economies are now behaving more responsibly than their Developed Country peers.
The following story, reported in the Financial Times on 08.09.09, is yet another reason why EMD is increasingly attractive.
“China will issue sovereign bonds denominated in its own currency to offshore investors for the first time this month – a crucial step towards making the renminbi a global currency. The country’s finance ministry said it would issue Rmb6bn ($879m) of bonds in Hong Kong on September 28, in a move to “improve the international status” of the currency and to help mainland companies raise funds in the offshore bond market.”
Few of the commentators that noted this even have, boldly and baldly, laid out its longer term significance to the world of risk. This Yuan Bond issue likely records the first official tolling of the death knell of the 10 year UST as the sole global risk benchmark. Within a decade, the 10 year UST will most likely be supplemented if not supplanted by the 10 year PRCT. Indeed, the spread between the UST and the PRCT will arguably become the world’s important risk metric; the issue has now been priced with the coupon on the five year set at 3.30%, some 110 basis points above its US equivalent. Is the likely coming together of the yields on US and Chinese Treasuries in coming years to become the ultimate convergence trade?
Recently Cheng Siwei, Vice Chairman of the Standing Committee of China’s National People’s Congress, noted that “The US spends tomorrow’s money today…We Chinese spend today’s money tomorrow. That’s why we have this financial crisis.” This is about to change. China is to start spending tomorrow’s money today, albeit not because it needs to but because it wants to raise Renminbi acceptability in global currency markets.
Given that the axis upon which the world of risk rotates is shifting Eastwards, the new True North will be heavily influenced by a Chinese bond trading within the EMD universe. As such, increasing exposure to EMD not only makes good immediate financial sense; longer term, it will be the university that teaches all bond investors what tomorrow’s world of risk might look like.