LONDON, 18 November 2002 — High yield and emerging market bonds have attracted attention because of their above average returns. Recently, both markets have increased in size and liquidity. High yield and emerging markets debt constitute two different asset classes with different risk/return profiles. Investors should optimally include 10 to 20 percent of high yield and emerging market debt in their global security portfolio, as they increase the total return without significantly changing the global risk.

In this research report, we analyze the impact of including three highly volatile assets classes: Emerging markets debt, emerging markets equity and high yield debt in terms of the risk/return characteristics of a global portfolio.

We considered monthly data from 31/12/93 to 30/06/01 and draw the following conclusions:

1. Adding exposure improves risk-adjusted returns.

2. Performance depends on time period.

3. Adding emerging markets debt combined with high yield debt improves long-term performance without introducing a significant change in aggregated global risk.

During the last 15 years, asset managers have included a small proportion (normally 3 percent to 5 percent) of emerging markets equity in standard portfolios to increase the global performance, by taking advantage of the low correlations of these markets with other asset classes.

Although this policy was very successful until the early 1990’s, since 1993 average returns of global emerging markets equity have dramatically declined, with the yearly average being negative (6 percent). This is in contrast to high yield bonds and emerging markets debts that have, respectively, shown annual returns of 5.89 percent and 9.75 percent with a volatility of 5.78 percent and 19.02 percent for the same period under consideration.

How should we choose the high return asset to diversify the portfolio optimally?

Should we include high yield bonds and/or emerging markets bonds instead of emerging markets equity within a typical balanced portfolio?

According to modern portfolio theory, we can increase the global performance of a typical portfolio by including a small amount of an asset that shows high average returns and does not correlate with the assets already in the portfolio. We consider a typical portfolio consisting of 70 percent of US Treasury bills and 30 percent US equity. We would like to include a high return asset and need to decide whether we would like to include emerging markets equity or emerging markets bonds and/or high yield bonds or any combination thereof.

Low asset’s correlation improves

diversification

The degree of correlations between the asset classes provides us with additional information. It is preferable to diversify a portfolio by including those assets, which have a low correlation to each other, even if volatility is high. Correlations with US equity are still relatively low (50 percent in the case of high yield and 60 percent in the case of emerging markets).

At first glance, we get the impression that we should have excluded emerging markets equity from our typical portfolio. However, to draw simple conclusions from the data obtained in the past might be misleading, as the results are very sensitive to the time period under consideration. By introducing much longer time series, the result reverses to a positive value of 5.68 percent average yearly return in the case of emerging markets equity and 8.47 percent in the case of high yield bonds.

What is the optimal “cocktail

of assets”?

We construct a balanced portfolio containing 70 percent of 3 month US Treasury bills and 30 percent of US equities, we calculate how the risk/return profile of the portfolio changes by replacing 10 percent of the US Treasury bills by high yield debt and emerging markets equity alternatively and mixed together.

The inclusion of high yield debt as well as emerging markets debt with a weighting of 10 percent, increases the global performance but also the risk. Finally, emerging markets equity increases the volatility and decreases the yearly performance of the global portfolio!

A combination of emerging markets and high yield debt increases the return with less pronounced increase in the global risk. An increase to 20 percent of the risky asset increases the global portfolio performance even further.

By altering the possible combinations of assets, we can derive the “efficient frontier” delivered by our basket of assets, and, thus we can obtain the “optimal portfolio”

US equity markets dried up

global markets

During the 1990s, the US equity market absorbed large amounts of international capital flows, drying up the amount of capital available to developing countries. The extremely good performance of the US equity market can be explained by the absorption of a large amount of international liquidity, drying up the rest of the markets. In fact, even the performance of European equity markets has been less impressive than the US during the early 1990s.

We believe that this situation is likely to change in the next years in some emerging markets countries but not in all of them. First, some emerging markets countries have already implemented orthodox economic reforms (Chile, Hungary), and hence inflation rates are converging to the OECD level.

Many emerging markets countries have also started their way to reform their institutional and legal environments. The improvement in the legal system allows emerging markets companies to concentrate their efforts on productive activities. Company’s accounting reporting of those firms listed in domestic stock exchange are getting closer to the requirement imposed by international accounting standards, making the disclosure of single firms much more transparent.

Concerning emerging markets debt, the “moral hazard effect” may diminish in the future as the position of IMF has dramatically changed. IMF refused to bail out a country (Argentina) forcing the default of senior debt (Eurobonds). We have observed also a change in the “contagion effect”. The Argentinean crises did not pose a negative impact on neighboring countries, and the whole asset class ex-Argentina performed extremely well in 2001. We do not expect moral hazard effect to completely disappear in the future, but the average yearly return might tend to decrease as well as the average volatility.

Although the years 2000 and 2001 have been negative for the European high yield markets, this can be attributable to the high weighting of a single sector in the asset class (media and telecommunications) which, showed a very poor performance.

Nevertheless, the issuance of debt by the other sectors (retail, gaming, food) is increasing, allowing investors for diversification within the assets class, as well as the implementation of sector rotation strategies. The amount of outstanding debt in the high yield area is also growing because of the inflows coming from the so-called “fallen angels”.

In conclusion, expect emerging markets debt and high yield bonds to continue to offer above average returns in the future. Due to the risk/return profile and the low correlation with other assets classes, it becomes optimal to include a combination of both asset classes within a typical global portfolio. In order to determine the optimal weighting of each asset class, it is necessary to compute forward looking expected returns.

The inclusion of 10 to 20 percent of a combination of high yield and emerging market debt increases the long-term return without significantly increasing the global risk of the portfolio. Investors should consider including a combination of these two assets in their global portfolios.

(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information)