Annual emerging market debt funds review

Nine years into the amazing emerging markets debt bull run, a new survey from Standard & Poor’s Fund Services, the leading provider of qualitative fund ratings, has some steadying remarks for investors starting to question how much longer the sector can continue to beat other asset classes.

In its latest annual survey of 32 emerging market debt funds Standard & Poor's Fund Services also identifies local currency debt as the big new trend in the sector, indicating that it expects to set up a specialist peer group for this important sub-sector soon.

In 2006, Standard & Poor's-rated emerging markets debt funds had another great year, outperforming the index and sector median in each of the US$ and Euro sectors. The median rated fund in the US$ sector returned 11.5%, outperforming the Lehman Emerging Markets Debt index by 1.5% points.

After a nine-year bull run, dating from the depth of the Russian default crisis in third quarter 1998, investors are beginning to wonder how long emerging market debt can continue to provide high returns relative to other asset classes, particularly given the tightness of spreads over US Treasuries. Having reached almost 16 percentage points in Q3 1998, these spreads are currently around two points.

“Spreads are at historical lows, but why should that stop any further contraction given the extent of structural improvement in emerging market economies?” asks S&P’s lead fund analyst Randal Goldsmith. “Why should there be a spread at all, for surplus countries anyway, when the US has spent and borrowed like Mr. Micawber?”

Goldsmith points out that although the US is always said never to have defaulted on its debt, investors have at times suffered significant loss of purchasing power from holding US government securities. Ironically, dollar devaluation has been part of the reason emerging markets debt performance has appeared so strong and consistent, because it is primarily expressed in US$.

“Even if there is some mean reversion of spreads, emerging markets debt may prove more defensive than other credit classes,” said Goldsmith, “Emerging markets spreads are still good compared to developed market corporate bonds and the default history is generally better, within given rating bands.”

Funds leading the outperformance included: S&P AAA-rated Ashmore Emerging Markets Liquid Investment Portfolio, with a 16% return, Threadneedle Emerging Markets Bond Fund (newly upgraded to AA) with 13.5%, ABN AMRO Global Emerging Markets Bond Fund (previously AA-rated but now under review following the departure of its manager) with 29.3% and AA-rated JP Morgan Emerging Markets Bond Fund with 13.6%.

As Standard & Poor’s Fund Services sees it, the big trend in the emerging market debt fund sector has been the move from mainstream, hard currency-denominated sovereign debt into local currency issues, with a number of launches of funds specialising in this area of the market. Standard & Poor's expects to set up a specialist peer group for the sub-sector fairly soon. However, it has already begun rating specialised funds, newly assigning an AA rating to Blue Bay Local Currency Bond Fund and A ratings to both HSBC Global Emerging Markets Local Debt Fund and INVESCO Emerging Local Currency Debt Fund. It is continuing coverage of AA-rated Ashmore Local Currency Debt Portfolio and UBAM Local Currency Emerging Market Bond Fund.