Emerging market bond investors have up to now been extraordinarily ill-served by the index compilers. Only JP Morgan has made a concerted effort to provide a benchmark index to track emerging market debt, and its Emerging Market Bond Index (EMBI) and EMBI+ have as a result become the market standards.
But the shortcoming of both indices has been their reliance on Latin American debt. Because the indices were weighted according to market capitalization of bonds, and involved quite stringent liquidity tests, they ended up being virtual proxies for Latin American sovereign bonds.
The original EMBI was weighted around 89% towards Latin America, while the more recent EMBI+ was still 78% weighted towards the region’s borrowers.
As such they failed to account for the ever-expanding universe of emerging market debt instruments, and acted as a deterrent for some investors looking for broad exposure to emerging market bonds.
“Speaking to managers it became clear that a broader index would have wider appeal and draw more money into the asset class,” says Peter Rappoport, head of portfolio research at JP Morgan in New York.
But for JP Morgan the problem couldn’t be solved simply by adding a whole new raft of countries to its existing indices in order to achieve a broader geographical mix. “The problem was creating an index that could achieve that, while including instruments that are investible,” says Rappoport.
The result was the dropping of previous liquidity tests, and instead introducing a more straightforward requirement that the bonds in the index should have easily accessible and verifiable daily prices from either JP Morgan or an external source. As Rappoport puts it: “The bonds have to be alive.”
JP Morgan determines eligible countries by using World Bank-defined per capita income brackets. Countries which have restructured their external or local debt will also be eligible, regardless of per capital income levels.
To have debt included in the index, the countries then need to have US dollar-denominated debt instruments of at least $500 million face value outstanding, issued by either sovereign or quasi-sovereign entities and with at least two-and-a-half years left to maturity.
The result is an index that includes 27 countries – 11 more than the EMBI+ – and 128 debt instruments. “I see it as something that should broaden the appeal of the asset class through diversification,” says Rappoport. “The EMBI-Global products will assume the role of an actual benchmark against which managers can be measured. Its broader diversification makes it a more viable competitor against other ways of earning spread.”
But for some fund managers the idea of tracking such an index remains counter-intuitive. “Anyone who understands these markets is being idiotic if they benchmark,” suggests Jerome Booth of London-based Ashmore Investment Management. “It is very much an information game. Your specialist knowledge has a real value and can be translated into excess returns.”
Ashmore’s Emerging Market Liquid Investment Portfolio includes 34 different countries at present, and has included 48 overall. According to Booth the five-year annualized return has outperformed the EMBI+ by over 400 basis points, while at the same time exhibiting significantly less volatility.
As the universe of emerging markets borrowers keeps growing JP Morgan is likely to have to keep updating its indices, and Rappoport says that more countries will be included in the index over time if they meet the required criteria. And although Booth isn’t about to give up active management in favour of index tracking he acknowledges that the EMBI-Global is a step forward.James Rutter
