Developed thinking in an emerging world Emerging Markets Debt For professional clients only
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Despite high volatility from a series of financial and economic crises, returns for emerging markets debt have generally outpaced those of traditional asset classes over the last ten years. An improving outlook and investors gaining increasing comfort has led to strong performance from many emerging market bond markets, contributing to higher longterm average annualized returns. Typically, low correlations between emerging markets debt indices and traditional asset classes highlight the potential diversification benefits of adding emerging markets bonds to fixed income portfolios. Significant evolution in emerging markets (EM) over the past 15 years Structural improvements in fiscal and monetary policy resulting in improved sovereign credit ratings in many emerging market countries Emerging markets debt is gradually assuming more importance in investors asset allocations The higher spread typically associated with emerging market bonds and relatively low default rates continue to attract a growing and diversified investor base Emerging markets carry, on balance, more risk than some traditional developed market investments Additional risk historically reflected in price volatility Regulatory, legal and governance practices are often less rigorous than their developed market counterparts Global emerging markets remained resilient during the recent crisis in the developed world Generally stable debt metrics and higher growth rates Many emerging market countries have very strong foreign currency reserve position The views and opinions herein are those of HSBC Global Asset Management, are subject to change without notice, and are based on current market conditions. The material is provided for informational purposes only, does not constitute advice or a recommendation to buy or sell investments, and is not intended as an offer or solicitation of a purchase or sale of any financial instrument or strategy. Any forecast, projection or target contained in this document is subject to change, is for informational purposes only and is not guaranteed in any way. HSBC accepts no liability for failure to meet such forecasts, projections or targets. Past performance is not an indication of future returns. All investments involve risks, including the possible loss of principal. Equity securities are more volatile than bonds and are subject to greater risks. Bonds are subject to interest-rate, price and credit risks. Prices tend to be inversely affected by changes in interest rates. Investments in high yield (commonly known as junk bonds ) are often considered speculative investments and have significantly higher credit risk than investment-grade securities. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging-market countries are greater than the risks generally associated with foreign investments. 3
The Case for Emerging Markets Debt There has been a significant evolution of emerging markets debt over the past fifteen years, with the asset class benefitting from structural improvements and an expanding investor base. The move away from fixed exchange rates coupled with increased foreign exchange reserves and more disciplined fiscal and monetary policies have improved fundamentals among many emerging market countries across Latin America, Eastern Europe and Asia. As a result of these improving fundamentals, many country s credit ratings have been upgraded and over half of emerging markets are now investment grade issuers (as seen in Chart 4). Because of the shifting risk profile and stronger fundamentals than most developed markets, emerging markets debt is gradually assuming a more important place in investors asset allocations. Sound long-term story We believe there is a strong long-term case for emerging markets, especially when compared to the weaker growth opportunities presently offered by many developed nations. Emerging market fundamentals, such as the debt / GDP ratio and current account balance, are significantly stronger than in many developed markets as shown in Chart 1. Chart 1. Gross public debt (EM vs DM) % of GDP 120 100 80 60 40 20 financial crisis. Consequently, during the past three years as many areas of the world found themselves in the throes of a recession, most emerging market economies continued to grow and increase their share of the global economy as seen in Chart 3. Chart 2. Emerging markets foreign currency reserves US$ Billions 9000 8000 7000 6000 5000 4000 3000 2000 1000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012F 2013F Emerging Economies Advanced Economies USA 0 1980 1985 1990 1995 2000 2005 2010 Emerging Markets International Reserves Source: IMF World Economic Outlook as of 30 April 2012. Many emerging market countries experienced financial crises in the 1990 s and early 2000 s stemming, in large part, from fixed exchange rates pegged to the US dollar. In response to these crises, most emerging market countries implemented monetary policies that abandoned the currency pegs and allowed their currencies to float, adjusting to economic and market developments. This allowed them to accumulate substantial foreign currency reserves, and by 2008, the international reserves in many emerging market countries exceeded their foreign debt, thus positioning them as net creditors for the first time. In April 2012 emerging market foreign exchange (FX) reserves were eight times larger than they were a decade ago as noted in Chart 2 and are nearly double the foreign exchange reserves of developed economies in general. Their strong positions allowed many emerging market countries to implement countercyclical policies during the 2008 global Source: IMF World Economic Outlook as of 30 April 2012. Chart 3. Shifting centre of gravity of the world economy Percentage of World 100% 80% 60% 40% 20% 0% 1980 1984 1988 1992 1996 2000 2004 2008 2012 F 2016 F Advanced Economies (GDP) Emerging Economies (PPP) Advanced Economies (PPP) Emerging Economies (GDP) Source: IMF World Economic Outlook as of 30 April 2012. 4
Strategic allocation for international fixed income investors Global emerging markets have continued to prove their resilience during the recent periods of stress in the developed world. Many emerging markets have experienced increased decoupling and have become less dependent on developed economies translating in much higher overall expected growth than for developed markets in general. For these reasons, we feel emerging markets will likely continue to outperform most developed markets on a structural basis as long as policy makers continue to employ sound macroeconomic policies. With the current low interest rate environment, we continue to see investors increasing their strategic allocation to emerging market debt given the potentially attractive yields and improving fundamentals of the asset class. These improving fundamentals as well as low financing needs generally provide emerging market countries more policy flexibility than developed markets, thus increasing the potential for their economies to continue growing at a faster rate. Quality at the right price While many developed market ratings have steadily fallen since 2009, most emerging markets ratings continued to rise. The relative change in credit ratings as seen in Chart 4 reflects the improving fundamentals of emerging market countries in general, namely stable debt levels, current account surpluses, controlled inflation, and tighter monetary policies. We believe these factors will likely promote faster economic growth and better return potential for investors over the long-term. Chart 4. EMBI Global credit quality 100% 80% 60% 40% 20% 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Investment Grade BB B Residual Source: JP Morgan, Bloomberg, HSBC Global Asset Management as of 31 July 2012. Expanding debt universe* The emerging market debt universe continues to grow. Global inflows to dedicated emerging markets fixed income funds have surpassed US$50 billion in July 2012. We expect continued expansion of the emerging markets debt universe as emerging markets GDP growth is forecasted at 4.6% growth for 2012 compared to 1.1% growth for developed economies. Compared to previous years, the majority of this new issuance in 2012 will likely come from investment grade issuers, rather than high yield issuers. For example, so far in 2012, approximately 80% of new emerging markets sovereign and corporate bond issuance has been rated investment grade. *Source: JP Morgan, as of 11 August 2012. Recently, while many European countries have been downgraded, the investment world has witnessed a significant number of credit rating upgrades in emerging market sovereigns and corporates, including those of Brazil, Peru, and Panama as highlighted in Chart 5. We expect emerging market sovereign upgrades to continue to exceed downgrades in 2012. Over 45 emerging market countries are now rated investment grade, equating to over 60% of the universe as can be seen in the chart on page 5. The better credit quality that many emerging market sovereigns have been able to achieve should provide some level of comfort to investors. 5
Chart 5. Trends in credit ratings: Emerging Markets versus Developed Markets 2000 2012 While emerging markets ratings have improved across the board, those in many of their developed counterparts fell over the period. All emerging markets nations below are now more highly rated than Greece, with only Venezuela ranked below Portugal. Many countries, such as Brazil, India, Mexico and Russia, now have an investment grade credit rating. Emerging Markets Developed Markets Non-investment grade Investment grade CC CC+ CCC- CCC CCC+ B- B B+ BB- BB BB+ BBB- BBB BBB+ A- A A+ AA- AA AA+ AAA Brazil Chile China Colombia Czech Rep. India Israel Malaysia Mexico Panama Peru Poland Russia Singapore South Africa Thailand Turkey Venezuela CC CC+ CCC- CCC CCC+ B- B B+ BB- BB BB+ BBB- BBB BBB+ A- A A+ AA- AA AA+ AAA Belgium France Germany Greece Ireland Italy Japan Netherlands Norway Portugal Spain Sweden Switzerland UK United States 2000 July 2012 Source: S&P as of 31 July 2012. For illustrative purposes only. Ratings are those of S&P and may differ from other rating agencies. 6
Understanding external (hard) currency and local currency indices External (hard) currency market Local currency markets The idea of owning an emerging market country s debt, but denominated in a global currency such as the US dollar, yen and euro, was founded on the notion that these currencies could prove to be a reliable hedge if an issuing country were to come under pressure. Over the past two decades, hard currency denominated emerging markets debt has earned a place in the core of many investors portfolios based on its improving credit quality and lower volatility. When allocating to the hard currency broad universe investment set, investors have access to over 70 countries in Latin America, Asia, Eastern Europe, Africa and the Middle East. The local currency market has grown steadily over the past decade as both sovereign and corporate issuers have been motivated to borrow locally allowing them to reduce the volatility of their debt service given their more flexible exchange rate regimes. This shift is particularly true for government bond issuers. In recent years, local-currency bond markets have expanded considerably in several countries. Growing interest from local investors, particularly from pension funds, has played a key role in the development of domestic debt markets in emerging markets. When allocating to the local currency investment universe, investors have access to over 45 countries in Latin America, Asia, Eastern Europe, Africa and the Middle East. Advantages and disadvantages External (hard) currency Local currency Advantages Disadvantages Advantages Disadvantages Mainly USD issuance Brady bonds and Eurobonds follow international law (low legislation risk) Borrower (issuer) generally pays a lower spread than in their own currency Longer duration High exposure to exchange rate risk (eg USD volatility) Historically lower yields for investor compared to local currency bonds in general Generally higher yields for investors compared to hard currency Real yields in local currency EM likely to continue trading at a premium as EM inflation is historically higher than in developed markets overall Shorter duration Historically higher protection against a rise in US Treasury yields Hedge against potential US dollar weakness Improving credit ratings of many local currency markets. Majority now rated investment grade Higher exposure to exchange rate risk Interest rate risk Regulatory risk Liquidity risk Higher volatility Benchmark characteristics Hard Currency (USD) JPM EMBI Global Div Index Local Currency JPM GBI-EM Global Div Index Duration (years) 6.82 4.56 Yield (%) 5.14 5.22 Number of countries in Index 48 14 % of sovereign 80 100 % of quasi-sovereign 20 0 % corporate 0 0 Source: HSBC Global Asset Management, JP Morgan as of 30 June 2012. The level of yield is not guaranteed and may rise or fall in the future. 7
Why HSBC Global Asset Management for Emerging Markets Debt? HSBC has been active in emerging markets for over 140 years and today is one of the world s largest managers of emerging markets assets with more than US$134 billion of client assets invested in local, regional and global emerging markets funds including approximately US$87 billion in emerging markets fixed income.* HSBC traces its roots back to its founding member, the Hong Kong and Shanghai Banking Corporation Limited, which was established in 1865 to finance the growing trade between China and Europe. In this respect, HSBC Group as a whole has been actively involved in emerging markets since the late 19th century. HSBC foundations are built on financing commerce in emerging market countries - this unique history has given us the heritage, expertise and investment acumen to achieve success for our business and more importantly our clients. Today, emerging markets debt is a core product offering for HSBC Global Asset Management and has been managed as a distinct asset class for over a decade. The creation and evolution of our emerging markets debt capability is highlighted below. We employ strategies and techniques that allow creative alpha creation and the potential for outperformance, all within the context of client specific goals, objectives and characteristics. Competitive advantages Investment approach HSBC s global footprint Extensive knowledge and insights from one of the world s largest emerging markets investment platforms. HSBC Global Asset Management employs approximately 200 emerging markets investment professionals across more than 15 emerging markets.* Coupled with HSBC s broader global banking network and HSBC Global Asset Management s global credit research platform, our emerging market debt team has unparalleled access to information and insights. We feel that this is a definitive advantage that cannot be easily replicated by competitors. Dedicated emerging markets debt resources The Emerging Markets Debt team is 100% dedicated to managing global emerging markets debt assets and is not encumbered with crossover mandates from non-emerging market strategies. The team works within a strong global investment and research platform that supports a consistent process and communication while empowering local decisions and the ability to tactically adjust portfolio exposures in the best interest of our clients. Risk adjusted focus The team has a historical track record of delivering strong investment performance in a variety of market environments. This is due in large part to our stress testing discipline which requires a constant recalibration of portfolios to ensure that positions are properly sized in an effort to achieve alpha and information ratio targets. We believe this differentiates our emerging markets capability from that of our competitors. It is also what has enabled our team to deliver stable tracking error in a variety of market conditions and has resulted in strong risk adjusted performance. Deep, innovative capabilities The team has demonstrated multi-strategy skill set and process using external debt, local currency and corporate debt, along with derivative instruments. The team continually aims to exploit the full universe of evolving opportunities in a strong risk management framework. *Source: HSBC Global Asset Management, as of 30 June 2012. Past performance is not an indication of future returns. Our approach to investing in emerging markets fixed income is built to profit from market inefficiencies. We employ a diversified, multi-strategy approach across the full opportunity set in emerging market debt including hard and local debt, corporate debt and currencies. Available strategies (inception date) Emerging Markets Debt Core (Hard Currency) October 1998 Emerging Markets Debt Total Return (Absolute Return) November 1999 Emerging Markets Local Debt August 2007 Emerging Markets Corporate Debt December 2010 Emerging Markets Investment Grade Debt December 2010 Emerging Markets Inflation- Linked Bond June 2008 Management of the strategy moved from Paris to New York in August 2012 8
Philosophy and process Goal Achieve strong, consistent risk-adjusted returns Investment philosophy We believe fixed income markets are inefficient We believe inefficiencies result from misunderstanding and mispricing risk We believe that fundamental research provides us the best opportunity to actively add value in fixed income portfolios Approach Active fundamental Strong risk management framework Using macro variables to build a ranking of country credits, currencies, rates based on their relative attractiveness Identify global themes / risks at the asset class level (leveraging global HSBC networks) Output: target beta, emerging markets asset class allocation Valuation analysis determines whether asset prices reflect our views on relative attractiveness Model portfolio construction attempts to maximize the opportunity between our fundamental views and market prices Stress testing contributes to portfolios seeking to meet their risk and return targets General strategy characteristics Emerging Markets Debt Core Seeks to capture improving credit quality of emerging economies while reducing foreign currency risk Invests predominantly in emerging market sovereign and quasi-sovereign bonds denominated in hard currency (USD) Spread compression and yield are key drivers of performance Tactical use of emerging market corporate bonds and local currencies Emerging Markets Debt Corporate Seeks to capture rapid growth and improving credit of corporate bond issuers in emerging economies Asset class has demonstrated generally higher yield and lower default rates vs. comparable developed market corporate bonds Team is able to leverage HSBC s extensive global emerging markets credit platform Emerging Markets Debt Investment Grade Emerging Markets Local Debt Invests in local currency sovereign bonds and emerging market FX Flexible approach allows for optimal asset allocation between bonds and currencies Price, currency appreciation and yield are the key drivers of performance Emerging Markets Debt Total Return Seeks positive absolute returns while reducing volatility normally associated with emerging markets Flexible access to the full emerging markets debt opportunity set, both hard and local currency Asset allocation decision is a key driver of returns No benchmark constraint allows flexibility to express short, medium, and long-term views Seeks to capture the growth and relative strength of investment grade rated emerging market debt assets Invests in debt issued by sovereigns, quasisovereigns and corporates in both hard and local currency Blended benchmark widens the investment universe and allows for optimal asset allocation between hard and local currency Emerging Markets Inflation-Linked Bond Only asset class offering a pure inflation-hedge; principal and coupon payments are indexed to inflation Low historical correlation with traditional emerging markets debt, helping to improve the overall riskadjusted return of an emerging markets debt allocation * Representative overview of the investment process which may differ by product, client mandate or market conditions. 9
Balancing the risk/reward premium Investing in emerging markets carries a heightened level of risk. Despite structural fundamental improvements and an expanding investor base, investment risks remain at a premium to developed markets. As many emerging markets are smaller than their developed market counterparts, relatively large inflows or outflows of capital can distort emerging market economies through more volatile asset prices, potential inflationary pressures, currency and interest rate volatility. In addition, political and economic instability, less publicly available information, potential for currency and capital market restrictions and changes to momentary policy are risks that are likely to be greater for emerging markets than in developed markets. Conclusion Emerging market nations are benefiting from a relatively strong economic backdrop and vastly improved fiscal and monetary circumstances which, in investment terms, has seen them move from a specialist choice for those with a healthy appetite for risk to a mainstream investment category that has a place in many types of portfolio. Emerging Market debt has proved itself an asset class that is capable of giving investors access to the potential growth in the region coupled with an attractive risk and return dynamic. These characteristics can mean that an investment in this category can contribute to diversification while at the same time potentially enhancing the expected return profile of a broad portfolio. As detailed, we have, over the last few years witnessed the continued merging of developed and emerging market sovereign ratings - demonstrated by the clear divide into the net creditor nations of emerging markets and net debtor nations of the developed world. This deep structural change in the global economic landscape we expect to continue and we are convinced that emerging nations will also continue to provide a clear investment opportunity - with emerging market debt providing a potentially attractive way to access the long term potential returns in this vibrant category. In order to access these opportunities investors need an institution with a deep understanding of the emerging markets terrain and a clear track record in dealing with the businesses, institutions and the changing superstructure of evolving nations. At HSBC Global Asset Management we bring to bear a team of highly experienced, dedicated emerging market professionals, many located in emerging countries, which have over time developed and honed their investment methodology, providing a degree of expertise that we believe is among the best available in the industry. 10
Important information This brochure is intended for Professional Clients only and should not be distributed or relied upon by Retail Clients. Risk considerations. There is no assurance that a portfolio will achieve its investment objective. In addition, there is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline. Accordingly, you can lose money investing in any of these strategies. Please be aware that these strategies may be subject to certain additional risks, which should be considered carefully along with the strategy s investment objectives and fees before investing. Equity. In general equity securities values also fluctuate in response to activities specific to a company. Foreign and emerging markets. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emergingmarket countries are greater than the risks generally associated with foreign investments. Fixed income securities. Subject to credit and interest-rate risk. Credit risk refers to the ability of an issuer to make timely payments of interest and principal. Interest-rate risk refers to fluctuations in the value of a fixed-income security resulting from changes in the general level of interest rates. In a declining interest-rate environment, the portfolio may generate less income. In a rising interest-rate environment, bond prices may fall. Credit quality. Investments in high-yield securities (commonly referred to as junk bonds ) are often considered speculative investments and have significantly higher credit risk than investment-grade securities. The prices of high-yield securities, which may be less liquid than higher rated securities, may be more vulnerable to adverse market, economic or political conditions. Convertibles. Subject to the risks of equity securities when the underlying stock price is high relative to the conversion price (because more of the security s value resides in the conversion feature) and debt instruments when the underlying stock price is low relative to the conversion price (because the conversion feature is less valuable). A convertible bond is not as sensitive to interest rate changes as a similar non-convertible debt instrument, and generally has less potential for gain or loss than the underlying equity security. Derivative instruments. Derivatives can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on performance. Non-diversification. Focusing investments in a small number of issuers, industries, foreign currencies or particular countries or regions increases the risks associated with a single economic, political or regulatory occurrence. Issued by HSBC Global Asset Management MENA, a unit that markets HSBC products in a sub-distributing capacity on a principal-to-principal basis, and is part of HSBC Bank Middle East Limited, PO Box 502601, Dubai, UAE, which is incorporated and regulated by the Jersey Financial Services Commission. HSBC Bank Middle East Limited is a member of the HSBC Group. Copyright. HSBC Global Asset Management 2012. All Rights Reserved. 22949/0912/FP12-1492 All decisions regarding the tax implications of your investment(s) should be made in connection with your independent tax advisor. 11
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