Increasing EM allocations could reignite structured appetite

The sovereign debt crisis in Europe and ongoing budget issues in a number of US states have served to switch investor attention towards emerging markets. With yields trending lower, this could lay the foundation for the re-emergence of structured credit products in the segment.

"The sovereign debt crisis acted as a wake-up call, given that there is huge institutional investor allocation to European sovereigns and the US," confirms Søren Rump, ceo of Global Evolution. "A default of a European country or a US state doesn't look completely unlikely; therefore many investors have had to rethink their asset allocation strategies and allocate more towards safer markets like emerging markets and gold."

He adds: "The emerging markets segment has traditionally been seen as risky, opaque and illiquid, with investors tending to focus on their own domestic market. However, that's changing now: EM is more transparent and liquid than it was 10-15 years ago, but also fundamentally these countries are doing well - they are experiencing higher growth and lower debt-to-GDP than in developed countries. In addition, the sector has performed much better than other markets during the crisis."

The Institute of International Finance points to buoyant local credit market conditions helping to restore strong growth in domestic demand in emerging Asia, for example, especially China. It describes this growth as having been "the leading edge of the global recovery". Net private capital flows to emerging economies are expected to total US$709bn in 2010 and US$746bn in 2011.

Global Evolution focuses on EM sovereign debt rather than EM corporate debt. During the 2008 crises the corporate segment performed badly. It is less supported, with less liquidity than sovereigns, according to Rump.

"We focus on frontier markets, such as Mongolia, because significant yield pick-up and upside to the currency are available," he explains.

Mongolia, for instance, has a wealth of largely untapped natural resources - which points to a significant influx of investment. "The country has a small economy (US$4bn GDP), but natural resources estimated to be worth around US$1.5trn," Rump continues. "This represents opportunity from a portfolio context in terms of adding to yield and diversification. We'd rather add upside in this way than in corporates."

The firm doesn't subscribe to the 'decoupling' story, however. Rump suggests that the biggest risk to EM in the near term is the global market tanking once again, because markets are so interlinked.

"If risk willingness declines, there will likely be outflows from EM," he says. "The main danger that we're looking out for is problems in the developed world."

Rump explains: "There are no major EM-related issues: there will inevitably be some political and economic problems cropping up in some countries from time to time, but they have generally reduced over the last 10-15 years. Emerging market countries are much more aware about attracting capital these days: they communicate better and provide more macro data, as well as outline their political goals and views in a more honest and transparent way."

In terms of structured credit activity in the EM space, investors have typically shied away from leveraged vehicles since the onset of the financial crisis. However, given that yields are trending lower, Rump expects investors to eventually begin looking at more leveraged products in order to hit certain return targets.

Rump adds that existing emerging market CDOs, for example, have performed well throughout the crisis because the EM sovereign sector has performed well. However, he points out that sovereign CDS are trading too tight and local currency debt yields are too low for CDO economics to make sense at present. There is also a practical problem in terms of the rating agencies' tightened criteria, particularly with respect to market value deals.

CS