by Jason Voss, CFA
It is a new era for global bonds and everything you know is wrong, PIMCO's global co-head of emerging markets portfolio management, Ramin Toloui, told delegates at the 66th CFA Institute Annual Conference in Singapore.
His point? All of the important market structures and ways of thinking about investing were put in place over the last many decades. But this environment was largely unswerving in its reverence for developed markets. In addition, it had very little of that most irritating of investor perturbances: volatility. As a result, fixed-income investors are all fighting the last war with the same strategies and the same weapons.
So what has changed? For starters, Toloui noted, there's been a transformation of international creditor-debtor relationships. Consider:
- Emerging markets now have positive current account balances, meaning that they now raise capital domestically.
- Emerging market international reserves are now approaching $8 trillion.
- In five years, the gross government debt-to-GDP ratios of the G20 nations have risen from 80% to around 120%. Over this same time period, the comparable stats for emerging markets are largely flat, with a government debt-to-GDP ratio of around 30%.
- Underemployment and unemployment plague first-world economies and a full jobs recovery has yet to occur post the Great Recession.
- Emerging markets represented virtually all of global growth in 2012, yet they only receive a 5% allocation in most global bond portfolios!
Notwithstanding these observations, investors view emerging market debt almost entirely as "juice" to add return to a portfolio. Yet the statistics suggest that "emerging market debt is the stable part of the portfolio." It used to be that investors most feared interest rate risk in industrial countries and credit risk in emerging economies, Toloui said. But now there are myriad examples of industrial countries where the credit story is more anxiety-inducing than the interest rate risks.
Am I correct that, as an investor, you have been carrying these prejudices, too? Here are the five areas where Toloui thinks they affect investors and their choices:
- Portfolio Construction: Investors should be integrating non-traditional strategies to position portfolios for market volatility. Greater cross-border credits equals greater risk diversification.
- Risk Management and Analytics: Investors should no longer subscribe to a "developed versus emerging market" dichotomy in which emerging markets are treated monolithically and as the "risky" part of the portfolio.
- Ratings Agencies and Investment Guidelines: National Statistical Ratings Organizations need to address the gap between credit rating and credit risk as they, too, suffer from the "developed versus emerging market" dichotomy.
- Asset Allocation and Organizational Stovepipes: Investors should seek to improve return versus risk trade-offs across the equity-fixed income divide.
- Benchmark Selection: Investors need to consider using GDP-weighted indexes to avoid the biases and capital misallocation inherent in market-cap-weighted bond indexes.
This last point deserves a brief explanation. Bond indexes currently are market-weighted, so as large, heavily indebted economies issue more debt, their weight in indexed portfolios must go up. That, in turn, lowers the cost of capital and the price of debt. This leads to more debt use and, hence, issuance. Vicious circles abound — and reinforce the old world order organized around the borrowing used to finance consumption.
The upshot? Unintentionally, emerging markets are being starved of capital, not because of actual credit statistics but because of the indexes that were built for a different era.
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