The case for emerging market debt
Lazard Asset Management's Arif Joshi demystifies emerging market debt and explains why it can offer excess yields.
Lex Hall: Hi, I'm Lex Hall and welcome to another edition of Morningstar's "Ask the Expert." Today, I'm joined by Arif Joshi, who's the Managing Director of Emerging Market Debt at Lazard Asset Management. We're going to talk about emerging market debt and why this asset class is worth looking at.
Arif, thanks for joining us.
Arif Joshi: Thank you for the invitation.
Hall: Now, emerging market debt, let's talk about what it is exactly, what are investors getting themselves into.
Joshi: Sure. So, there are a couple of different ways to access the asset class. Governments in emerging markets, they issue debt either denominated in U.S. dollars for in local currency. The safer way to play the asset class is through the dollar denominated debt side because you're not taking currency risk. You're basically trying to figure out the willingness and the ability of these countries to pay you back. To the extent that you go to the local currency side, you are taking currency risk, and as a result of that typically you require more compensation for taking that currency risk. That is the government debt side. And then, the other side is the corporate debt side. So, these are the companies within those emerging market countries that also issue debt and that is primarily at this stage a dollar denominated debt asset class.
Hall: Okay. So, we're talking about bonds here, IOUs essentially.
Joshi: That's correct.
Hall: So, you're lending governments or companies money so that they can carry out their activities?
Joshi: That's right.
Hall: Yeah. Okay. Now, emerging market debt has sort of had a bit of a bad rep over the past 20 years, let's say. You've had in 1994; you had the tequila crisis, the so-called Mexican peso crisis; you had the Asian financial crisis of '97; a year later the Russian financial crisis; then you had Argentina default. What's changed? Why should we be looking at it now?
Joshi: Sure. So, that was a depressing start to the question. But that is actually one of the reasons why you get excess yields to invest in this asset class. So, people remember exactly as you said the rolling of defaults in Asia, the Russian crisis, Argentina, which has been a serial defaulter within emerging markets. And what that doesn't tell you is that in fact when you lend to emerging market countries, and when you buy emerging market debt, these countries, on average, have half of the debt than the rest of the world. So, as an example, in the United States, there is 95% debt to GDP ratios, debt as a percentage of your economy. In Europe, it's a similar type of number. In Japan, it's 250%. Yet the average emerging market country only has 50% debt to GDP. So, you are not getting paid more in yield to invest in these countries because they have worse debt. In fact, they have better debt ratios. You're getting paid more largely because of the history of emerging markets, what happened 20 years ago, and that's why people tend to really demand extra premium to get into this asset class.
Hall: Okay. We'll allow you to contradict me there because some of the returns have been quite good, haven't they? And I say that in the context of – obviously, the past 10 years or so, the interest rates have just been sliding and the hunt for yield has become so much more acute, hasn't it? So emerging market debt for investors is worth…?
Joshi: Sure. So, looking backwards over the last 15 years, this has been one of the top three performing fixed income asset classes in the world. You have gotten outsized returns for investing in emerging market debt. We also have higher yields than you'll typically find in the rest of the world. So, we typically have yield of 5% to 6%. And you know in the rest of the world, it's a number that's closer to 0 to 2%. So, looking backward, exactly to your point, you have gotten extra returns in emerging market debt, one, because of global yields have gone lower, and second, because these countries have actually managed their finances much better than what you've seen elsewhere. So, it's been a very attractive place to be looking backwards. And then, the key question is what parts of this market will be attractive looking forward over the next one to two years.
Hall: Okay. Let's talk about risk because with high return there's higher risk. What are some of the red flags that investors should be looking for?
Joshi: In any fixed income market, the number one risk is default risk. So, you no matter how much you earn in lending to these different countries, if you have significant defaults, you will have that wasted away. One thing that people are surprised that is that over that same period, the 15-year period that I talked about earlier, emerging markets actually have significantly lower default rates than what you find in the developed world. And again, it is because they're running much stronger balance sheets. Fiscal deficits in these countries are much smaller than what you're going to find in the developed world. So, these countries have actually paid back at a much better pace than typically what you have found in the developed world. So, as long as you're investing in emerging market debt, and your fund manager is doing their bottom-up credit homework, understanding which countries are on a deteriorating path versus countries that are on an improving path, and you keep that default rate low, you should be able to realize those excess returns.
Hall: Okay. And on that liquidity, how do I get my money back?
Joshi: Yeah. So, emerging market debt is in fact quite liquid. All of the strategies that we run are daily liquidity strategies. So, to the extent that you want your money back, you can get it back daily. In order to do that, specific to how we manage emerging market debt, we stay in the liquid part of the asset class. So, we are lending to governments, as you mentioned earlier, in bond form. So, we're not direct lending. These are not loans that are not traded. So, these are bonds that are traded in the market on a daily basis so that if the view on markets change, you can get your money back on a frequent basis.
Hall: Okay. Arif, thanks for your insights. We'll follow up with another video where we'll drill down into some specific products and some specific sectors. Arif, thanks for your insights.
Joshi: Great. Thank you very much.
Hall: Thanks for watching.