Global Investing

The people buying emerging markets

We’ve written (most recently here) about all the buying interest that emerging markets have been getting from once-conservative investors such as pension funds and central banks. Last year’s taper tantrum, caused by Fed hints about ending bond buying, did not apparently deter these investors . In fact, as mom-and-pop holders of mutual funds rushed for the exits,  there is some evidence pension and sovereign  wealth  funds actually upped emerging allocations, say fund managers. And requests-for-proposals (RFPs) from these deep-pocketed investors are still flooding in,  says Peter Marber, head of emerging market investments at Loomis Sayles.

The reasoning is yield, of course, but also recognition that there is a whole new investable universe out there, Marber says:

There has been so much yield compression that to get the returns investors are accustomed to, they have to either go down in credit quality or look overseas. Investors have been globalizing their equity portfolios for 25 years but the bond portfolios still have a home bias. We are starting to see more and more institutional investors gain exposure to emerging markets, and a large number of recent RFPs highlight more sophisticated mandates than a decade ago.

The allocation swing has been especially marked since the 2008 crisis and subsequent Fed money printing that flattened yields across developed markets – the IMF estimated earlier this year that of the half trillion dollars that flowed to emerging bonds between 2010-2013, 80 percent came from big institutional investors.

Here is a chart provided by the Institute of International Finance that shows the stark contrast between retail and institutional investors’ emerging market holdings:

Indian risks eclipsing other BRICs

India’s first-quarter GDP growth report was a shocker this morning at +5.3 percent. Much as Western countries would dream of a print that good, it’s akin to a hard landing for a country only recently aspiring to double-digit expansions and, with little hope of any strong reform impetus from the current government, things might get worse if investment flows dry up. The rupee is at a new record low having fallen 7 percent in May alone against the dollar — bad news for companies with hard currency debt maturing this year (See here). So investors are likely to find themselves paying more and more to hedge exposure to India.

Credit default swaps for the State Bank of India (used as a proxy for the Indian sovereign) are trading at almost 400 basis points. More precisely, investors must pay $388,000  to insure $10 million of exposure for a five-year period, data from Markit shows. That is well above levels for the other countries in the BRIC quartet — Brazil, China and Russia. Check out the following graphic from Markit showing the contrast between Brazil and Indian risk perceptions.

At the end of 2010, investors paid a roughly 50 bps premium over Brazil to insure Indian risk via SBI CDS. That premium is now more than 200 bps.

Pension funds’ hedging dilemma

Pension funds have no shortage of concerns: their funding deficits are rapidly growing in the current low-return environment, and ageing populations are stretching their liabilities.

But a recent survey of pension funds trustees by French business school EDHEC has found that their biggest worry, cited by nearly 77% of the respondents, is the risk that their sponsor — the entity or employer that administers the  pension plan for employees – could go bust. Yet 84% of respondents fail to manage the sponsor risk.

So how do you hedge against such a risk?

You could buy credit default swaps of the sponsor company or buy out-of-the-money equity put derivatives to seek protection. But both options are costly and illiquid. Moreover, it might send a negative signal to the market: after all, if the company’s pension fund is seen effectively shorting the company in an aggressive manner, investors may wonder “What do they know that we don’t?”