First Republic Investment Management

Volume 13: 3rd Quarter 2010

Panorama: Emerging Market DebtBy Stephen Marotto

Concerns over mounting debt and declining credit quality in the developed world are everywhere these days. Whether you pick up your local newspaper to find headlines over distressed munici­palities or turn on CNBC to hear one of the talking heads ranting about a European sovereign debt crisis, you are constantly con­fronted with credit worries in developed nations. These credit woes lead many investors to look to emerging markets for alternative opportunities.

The Emerging Story

Emerging markets, which include the larger “BRIC” economies (Brazil, Russia, India, and China) and many of their smaller neighbors, are well-known for high growth potential and strong stock market returns in recent years. Now, to a greater extent, these emerging economies are being touted for their relative financial strength in both the public and private sectors.

Over the coming decades, emerging economies, led by the BRIC nations, are expected to grow faster than developed economies such as the U.S., Japan, and Eurozone. In fact, the International Monetary Fund website estimates emerging and developing economies to grow by 6.8% and 6.4% in 2010 and 2011, respectively, and expects advanced economies to grow by 2.6% and 2.4% in 2010 and 2011, respectively. The growth story in emerging markets largely stems from demographic trends that are suggestive of an increase in domestic demand. For instance, Matthews Capital International, LLC, a San Francisco-based investment firm focused exclusively on Asia, reports that Chinese consumers now comprise the world’s largest market for automobiles. Increasingly, however, growth is also expected to take shape as a result of a governmental shift in priorities from economic policies that focus on boosting exports to such policies that stimulate internal consumption and prosperity. Matthews also reports in the coming years that China plans to build approximately 30,000 new hospitals and medical facilities.

In addition to building more balanced economies through promoting domestic demand, fundamental figures of emerging sovereign govern­ments show signs of relative strength. According to PIMCO, the world’s largest bond manager, emerging sovereign governments have accumulated larger international currency reserves, carry relatively lower debt-to-GDP ratios, and run greater current account sur­pluses than their G-7 counter­parts. This fiscal strength provides a financial cushion in times of market crisis or economic vulnerability.

From an economic perspective, we believe that both strong sovereign policy and fundamentals are likely to stimulate domestic consump­tion, support global market integration, and sustain long-term growth.

The Opportunity Set

Healthier financial balances in the world’s emerging markets provide U.S. investors with an expanded opportunity in fixed income investing. From a portfolio management perspective, a prudent allocation to emerging market debt may provide a U.S.-based investor with enhanced total returns and reduced portfolio volatility. Higher total return potential may be achievable through relatively higher real (inflation-adjusted) country yields, spread compression (bond price appreciation) as eco­nomic development and global integration takes shape over time, as well as participation in emerging market currency appreciation versus the U.S. Dollar (if the debt is denominated in local emerging currency). While the return profile may appear attractive, investors should consider additional political, economic and financial risks. The marketplace for emerging debt is expanding rapidly as governments need capital to fund infrastructure projects and corporations require cash to meet critical growth objectives. The aggregate size of the current emerging sovereign and corporate debt market stands well beyond ­­ 1 trillion USD, representing approximately 9% of the global bond market. According to Wall Street Journal reports, the majority of new emerging market bonds issued in June and July of this year carry an investment-grade rating, a phenomenon which has pushed the current average credit rating of the J.P. Morgan EMBI Global, an index of USD-denominated emerging sovereign bonds, from speculative grade to investment grade quality. Over the past ten years ended June 30, 2010, the same index has recorded an annualized return of 10.36%. Strong performance is largely attributed to relatively higher coupons (interest payments) and strong price performance (tightening spreads) over time as emerging bonds are increasingly viewed as less-risky investments by market participants.

How We Invest

Our dedicated investment research team is actively engaged in researching and monitoring emerging debt markets as well as searching for compelling strategies that invest in them. Where suitable, our investment professionals may offer these specialized investment strategies to our clients. The strategies that we provide are guided by experienced investment teams that seek to invest in corporate, infrastructure and sovereign emerging market bonds as well as emerging currencies.

As with all investments, investors should be aware of the risks inherent in the emerging market bonds, such as interest rate risk, currency risk, sovereign/political risk, credit risk and liquidity risk. Emerging market bonds are not appropriate for every investor.