A fundamental risk model, known as Frisky, helps Investec’s Peter Eerdmans avoid the inevitable pitfalls of investing in emerging market sovereign debt, with outstanding results.

Five years ago, a market in emerging market sovereign bonds, denominated in local currencies, barely existed. Today, almost by stealth it seems, these bonds are a $1 trillion asset class, and one that has so far served early callers in the burgeoning market remarkably well.

Investec was one of the pioneers in this new market and boldness has been its friend. From a standing start in 2006, Peter Eerdmans, Investec’s head of emerging market debt, now manages a pot of securities worth $9 billion (£5.5 billion) in several funds, and UK investors in Investec Emerging Market Local Currency Debt, in sterling terms, have reason to feel smug.

In its first full year, 2007, the fund delivered a 17 per cent gain, followed by 23.8 per cent in the momentous year of 2008, 12.7 per cent in 2009, and 17.6 per cent last year. Since launch, the annualised growth rate of 15.9 per cent is one that equity managers will eye with envy, even if much of the growth was due to the weakness of sterling.

This year, however, the outcome will be more modest. Unless the landscape changes radically, the gain of just 3.3 per cent so far this year is a good portent of what lies ahead for the whole of 2011. But life is about change and changes in the debt markets do not come much bigger than the shakeout in the European and US debt markets.

Eerdmans, the day after the political stand-off in Washington concluded with a deal that forced president Obama to slash federal spending by more than $2 trillion, reckoned it ‘reasonably likely’ that the US would lose its AAA rating. Barely a week later ratings agency Standard & Poor’s downgraded US sovereign debt to AA+. 

‘The precarious situation will continue to flag to investors that emerging markets are in pretty good shape compared to the developed world,’ he says. This will only increase investor appetite for emerging market debt, he feels.

‘The measures that have to take place over the next five years in the US and Europe are a tax on growth, with government contributing less. Emerging markets have a lower debt base. They have the room to increase borrowing and spending on education, infrastructure, and social services. This means economic growth will be a bit bigger than it otherwise would have been.’

Eerdmans primarily invests in public-sector and sovereign debt, with about one-third of his fund devoted to issues from Brazil, Hungary, Malaysia, Mexico and Turkey. Just one-third have an A credit rating. More than half is classified BBB and BB; or ‘junk’ bonds, a term Eerdmans dislikes. 

‘The market for local currency emerging market debt is now larger than the market for emerging market dollar debt. The high-quality countries are the biggest players,’ he says, with frontier markets likely to emerge more forcefully.

His asset class, he says, appeals to two main types of investors. ‘The risk-seeker who wants volatility and yield. He is still there. But what is risk these days. The dollar? The euro? That is why the flows have been so strong into my asset class. The second main investor is the sovereign wealth fund. They are now in the market for this debt.’

Some 80 per cent of Eerdmans’s funds are owned by these and other institutional investors. He says just 60 per cent of countries in his investment universe had investment grade status five years ago, but the level has now risen to 75 per cent; reflecting structural reforms, such as better fiscal and monetary policies.

The available yields on emerging market debt put the debt of this country, for instance, into the shade. In sterling terms, Eerdmans’s fund has a distribution yield of more than 6 per cent, and an underlying yield of 5 per cent. He accepts that currency exposures bring additional risks, but holds the view that as countries move from emergence to development, their currencies can be expected to appreciate.

‘We take strategic country and currency views for six, nine and 12 months ahead,’ Eerdmans says, ‘and this is where we can add value.’ There are 11 people in his team and specialists visit their regions as many as four times a year. ‘We meet the policymakers, the opposition, university professors, journalists and asset managers.’

The selection process begins with a computer program known as ‘Frisky,’ a model developed to assess ‘fundamental risks’. These include a country’s reserves and how they relate to money supply; the state of the current account and levels of direct investment; and the value of a currency against a basket.

Eerdmans, a graduate in econometrics, says that in 2008 to 2009 the program pointed to a likely crisis in eastern Europe. ‘We build our positions and focus on the downside risks. It is nice when the securities go up but then there will be a negative year; the program helps us avoid these.’ He adds: ‘We can invest in any country outside the G10.’ Currently, the exposure to ‘frontier’ countries is limited to Ghana, Nigeria, Ukraine and Zambia.

All investors face risks from inflation but in the bond market they are more acute. Here, Eerdmans is relatively relaxed. ‘Inflation is at the top of our comfort zone and there is a lot of liquidity flowing into these emerging countries. We believe, however, that inflation is peaking, particularly in Asia, where we see demand-driven inflation, but tightening monetary policies.’ 

He reckons inflation is less of a risk than hitherto, however, largely because central banks are increasingly independent of their political masters. ‘Economic management across the world is better than it used to be and I do not see inflation spiralling out of control.’ This helps explain why the ‘maturity profile’ of his fund has a 30 per cent exposure to bonds maturing within the next five to 10 years, and more than 10 per cent in 10 to 20 years.

Like all fixed interest managers, Eerdmans makes use of derivatives to protect his positions. On balance, he expects to make half his gains from currency positions and the balance from active management of the bond portfolio. In Brazil, for instance his bonds produce a real yield of 6.5 per cent and there is scope for a ‘steady convergence play’ as yields fall. ‘But I am sceptical about the currency and we have hedged against it.’ This compares with yields of around 4 per cent in Thailand and Malaysia, and 1.6 per cent in Taiwan. 

He turns over less than half his fund a year. ‘For a bond fund, that is low. But we are more active on currencies.’ And he says the risks to his bond markets are now benign. ‘There isn’t an inflation risk because of better economic management; but there clearly is a risk from global sentiment.’

But, Eerdmans implies, investors need to keep an eye on the cycle. ‘We haven’t had a proper emerging market crisis since Russia and Asia in the late 1990s. But there will again be over-investment, with bubbles forming. But I think these worries are between three and five years away.’

Eerdmans's snapshot of emerging market debt

Argentina: The market is complacent on the risk.

Brazil: Overweight the bond market, underweight the currency.

Chile: Bonds, neutral, overweight the peso.

China: Better opportunities lie elsewhere.

Egypt: We expect adverse reaction to the currency going into the elections.

Ghana: Potential for appreciation of the cedi as oil production increases.

India: We remain positive on the currency.

Indonesia: Valuations in the bond market are stretched. We are underweight the rupiah.

Israel: We hold an overweight in Israeli eurodollar bonds, against a South African underweight.

Kenya: An attractive tactical long play.

Malaysia: Positive local currency bonds.

Mexico: Overweight the currency, underweight the bonds.

Russia: A long rouble position. The oil price strength has done the country a massive favour.

South Africa: The rand remains expensive.

South Korea: There is room for further currency strength.

Taiwan: We maintain a short position in the Taiwan dollar.

Thailand: Underweight in bonds, overweight the baht, but may look to take profits.

Turkey: The lira still offers value versus the rand and is cheap both in historical terms and on absolute purchasing power parity.

Ukraine: The currency remains cheap relative to peers and there is a long-term convergence play relative to the CIS region.

About Peter Eerdmans

Age: 41

Position: Head of emerging market debt, Investec. Manager of Investec Emerging Market Local Currency Debt and associated funds.

Education: Erasmus University, Rotterdam.

The past: Global bonds department, Robeco. Investment consultants Watson Wyatt. Joined Investec in 2005.

Home: Woldingham, Surrey. Bird watching. Three children.

Finances: A diversified bond and equity fund portfolio.