LONDON (Reuters) - Investors are criss-crossing the increasingly smudged line between emerging and developed markets as the euro zone crisis challenges traditional perceptions of a safe investment.
This blurring of distinctions was illustrated last month by index compiler MSCI’s surprise decision to review Greece’s stock market for downgrade to emerging market status, usually assigned to poorer countries offering lower liquidity and less open access to trade.
Although Greece remains a member of the euro zone, multiple credit rating downgrades, a debt restructuring, shrinking stock prices and the persistent risk it will be forced to exit the bloc and sharply devalue its currency have given it a risk profile similar to those of many developing countries.
That being so, many investors may prefer to take their chances in traditional emerging markets such as South Africa or the Philippines.
“This is a huge factor driving emerging markets -- it’s obviously driven in part by the change in the risk in developed markets,” said Jerome Booth, head of research at Ashmore Investment Management, which manages $66 billion in emerging market assets.
“This has been happening for 15 years. It’s speeded up since the financial crisis -- it’s an ongoing issue but for big institutional investors, the decision to start can be followed by the actual investing only two years later.”
Reflecting the increasingly broad range of investors who are seeking out emerging market investments, Booth said central banks and sovereign wealth funds made up 40 percent of Ashmore’s assets under management.
Inflows into emerging market bond funds totaled $23 billion in the first half, while inflows into emerging equity funds totaled $14 billion, according to data from Boston-based fund tracker EPFR.
Meanwhile, outflows from developed Europe equity funds were $22 billion over the same period. Outflows from developed Europe debt funds totaled a smaller $1 billion, but followed a $29 billion exodus in 2011.
To mop up the increased demand, emerging market borrowers are likely to issue record amounts of debt -- totaling close to $300 billion -- this year.
The uncertain outlook for the euro zone, whose policymakers are struggling to convince markets they can get a grip on the sovereign debt crisis now in its third year, have pushed up borrowing costs for leading economies such as Spain and Italy.
Spain’s 10-year debt is trading close to the 7 percent danger level at which other euro zone countries including Greece were forced to seek aid, while Italy’s borrowing costs are nearing 6 percent. By contrast, junk-rated Turkey recently issued dollar debt at a yield of less than 6 percent.
For a core euro zone borrower like Germany, 10-year yields are puny, at less than 1.5 percent.
“The theme that has been in place for a while is to go underweight more mature developed economies such as the United States, UK and the core euro zone and use that underweight to invest in markets that have better long-term fundamentals,” said Peter Wilson, managing director of First International Advisors, a subsidiary of Wells Fargo.
Wilson favors local currency debt in markets such as Mexico, South Korea, South Africa and the Czech Republic.
Whereas Greece was kicked out of global bond indices benchmarked by many investors two years ago, South Africa will join Citi’s world bond index later this year.
Foreign holdings of local government bonds have nearly tripled in Mexico and nearly doubled in South Africa since 2007, according to JP Morgan.
Emerging market companies are also looking more attractive than in the past, paying higher dividends and showing stronger earnings growth.
“Companies are making better return on equity than (in) the developed world,” said Laurence Taylor, portfolio specialist in global equities at T Rowe Price.
“That was not the case in emerging markets 10 years ago.”
Emerging market fund managers say they have been seeing many more RFPs -- requests for proposals -- from institutional investors such as pension funds and sovereign wealth funds which are looking to start buying emerging market assets.
“It’s still mandate restriction-driven -- G10 and non-G10 mandates -- but these lines are getting blurred,” said Werner Gey van Pittius, who co-manages $10 billion in emerging debt at Investec.
Moving further down the traditional risk profile, demand has also been huge for the small supply of new debt from so-called frontier markets.
Dollar bonds issued by West Africa’s Gabon and Ghana in 2007, before the heights of the financial crisis, are trading at respective yields of 5.7 percent and 4.3 percent, well below launch levels of above 8 percent.
“Yields show African bonds are perceived to be less risky than some of the European ones right now,” Ravi Bhatia, sovereign ratings analyst at Standard & Poor‘s, told a briefing last week. “A lot of people are trying to get out of Europe and into emerging market assets.”
Emerging markets still carry their own risks, however, not least because as they become more sophisticated, their trade, banks and market prices are increasingly linked to the rest of the globe. Emerging stocks fell more than 20 percent last year and the giant BRIC economies - Brazil, Russia, India and China - are starting to falter.
“We see risks as being connected,” said Percival Stanion, who runs a 9.7 billion pound multi-asset strategy at Barings Investment Management.
“We are wary about the euro zone, and this is reflected in our wariness about other risk assets -- emerging markets are obviously a high risk area.”
But for those who really want to take a punt, there is always the opportunity to go the other way.
Broker Exotix, which specializes in frontier debt, started covering Greek, Portuguese and Cypriot debt this year, and recommends buying Greece’s restructured bonds.
As Greece does not feature in any emerging debt indices, some specialist fund managers may be constrained by their mandates from buying it, but it is starting to appeal to risk-loving investors.
“A lot of ... emerging market-type hedge funds invest in Greek bonds today,” said Julian Adams, CEO of London-based hedge fund firm Adelante Asset Management. “It’s taken a while for the mentality to shift.”
Additional reporting by Sujata Rao and Laurence Fletcher; Editing by Catherine Evans