Emerging market debt fund managers remain positive

Most of the managers of emerging market debt funds rated by Standard & Poor’s Fund Services are positive on the outlook for their sector and have been taking advantage of recent market uncertainty to increase their exposure.

“Emerging markets are seen as less vulnerable than before because they have healthy balance sheets,” said S&P Fund Services lead analyst Randal Goldsmith, whose latest update on the sector is available at funds.standardandpoors.com.

“Many emerging market countries are net creditors and have trade surpluses,” Goldsmith explained. “There is a greater prospect of sovereign issues from such countries being in short supply than there is a risk of default. That is why emerging markets proved relatively robust through this period of financial stress compared with 1998, when Russia defaulted on its debt.”

Goldsmith noted that a number of managers were rethinking their perception of local issue risk, trying to assess whether risk has been overestimated in the spreads between US Treasuries and emerging market debt. “The thinking is that US government issues have been the standard against which emerging market issues have been measured when the fact is that amongst Western developed markets the US and the dollar are a little bit more prone to loss of purchasing power. One indicator of this is the rise in gold priced in US dollars to a 27-year high.”

The managers interviewed by S&P Fund Services agreed that the main risk to emerging markets debt comes from weaker global growth led by tighter lending standards and the wealth effect from falling equity and property. However, they viewed last week’s half percentage point cut in the Fed Funds rate – at the more optimistic end of expectations – as reducing that risk.

Over the three months to September 2007 covered by the S&P Fund Services update, overweighting emerging European debt helped the relative performance of emerging markets debt funds, with the region seen as a safe haven during a time of stress. In contrast, exposure to emerging markets based corporate bonds was generally a drag on returns.

“Our research revealed that fund managers added value through holding local currency sovereign emerging markets debt,” said Randal Goldsmith. “Some of the funds have restrictions on investing in local currency issues and this detracted from their relative performance within the peer group.” He gave the example of the ING Renta Fund – Emerging Markets Debt Hard Currency, which fell from top to bottom quartile within the peer group primarily because the mandate does not allow the manager to have local currency exposure.