Good business in emerging markets

In a world of declining returns, emerging market bonds stand out, argues ABN Amro.

Raphael Kassin, London-based head of emerging-market fixed income at ABN Amro Asset Management, says his global portfolio can generate at least 10-15% over the next six to 12 months, attributing 8-9% to the coupon and the rest to trading.

"What other asset class can give you this kind of return?" he asks.

Kassin acknowledges the asset class has a cowboy image, derived from the revolving door of emerging market crises, but believes this is outdated, and that emerging market bonds' track record suggests a much more mainstream profile. Cumulative returns of the EMBI Global index over the past decade have outstripped US and global bond indices, as well as US and emerging market equities. He says on a risk/return basis, over the past 10 years emerging-market bonds have demonstrated superior information ratios versus traditional asset classes. Most of the investible universe is denominated in dollars or euros and is issued by sovereigns in the form of Eurobonds - as opposed to Brady Bonds from defaulting governments. The market is also a lot more liquid now, particularly on the long end of the yield curve. And emerging market bonds are not highly correlated to other asset classes.

Spreads have tightened considerably for many developing countries' sovereign bonds. The EMBI Global's average spread against US Treasuries is now 330 basis points, the tightest level since just before the 1997 Asian financial crisis. But Kassin says spreads will continue to tighten, because whereas in 1997 only 20% of the EMBI constituents were investment grade, now 45% are.

This is also the first year since 1998 that the market is not characterized by cheap bonds and easy capital appreciation. But this means that profits will come increasingly from trading, and new opportunities are opening thanks to volatility in US Treasuries and debates over interest-rate policy at the US Federal Reserve Bank.

Moreover, Kassin doesn't see another big developing country go into default. Countries like Russia and Brazil have reasonable finances, stable politics, well-managed foreign exchange reserves and low foreign debt. Moreover by the end of the first half of 2005, governments will have met their international borrowing needs, which means overall there will be less supply in the primary market. That, plus a growing demand for yield among investors will buoy the asset class.

Kassin thinks this year will see a bet on Argentina pay off. Argentina now comprises 10% of his global portfolio. ABN Amro lost money when Argentina defaulted in 2001 but it decided to participate in Buenos Aires' restructuring effort and in the secondary market bought Argentine debt at an attractive yield. These are now trading at around 10%, more than 100bps higher than Brazil's government bond, and warrants linked to Argentine GDP growth are already in the money. If the IMF approves Argentina's debt restructuring this year, the country will return to global indices and the surge in investment will spark a rally.

The portfolio also traded out of Turkey and Brazil last year, before collapses in those markets' bonds, and bought them back more cheaply in January. The portfolio now has an allocation of 32% to Venezuela, 23% to Brazil, 20% to the Philippines, 6% to Russia and 9% to cash.

The firm manages risk with cash. Its tracking error band is 7-13%, and if tracking error gets too high, it increases cash, although currently tracking error is very low. Although spread trades are possible in Asia, for the most part the portfolio invests only in long-term bonds, 10 years or more, partly because the long end is more liquid, but also because if there is a default, long-term bonds have a better chance of being restructured.

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