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As their economic fortunes continue to improve, emerging market (EM) countries are looking to spend on clean water, energy, transportation, utilities and other national infrastructure projects. These investments should raise the quality of living for billions of people and drive growth in EM nations.

Such development projects will likely also produce global investment opportunities, because they are often financed with securities that typically offer yields normally associated with non-sovereign debt yet carry risk profiles closer to those of sovereign issuers. 

The condition of the balance sheets of several EM countries during the last several decades of the 20th century diverted their attention from long term investment needs (such as infrastructure) toward more immediate crisis-related needs such as reducing high real interest rates, inflation and public debt. This is no longer the case.

Stabilization Sets the Stage for Dramatic Increases in Infrastructure Spending
Indeed, once several EM countries were able to get out of this turmoil, balance sheets started improving, public and private sectors began to shed debt, fiscal balances improved and, finally, external deficits began to close.

At the start of the current decade, infrastructure investment in many emerging countries had fallen below the levels of 10 years earlier, driven by declines in public funding and private investment flows.

Now that developing countries are moving from crisis mode to sustained development, infrastructure spending will be a critical lever to ensure the recent improvements in EM growth continue.

Why Infrastructure Now
Infrastructure investment needs in developing countries around the globe amount to about 7% to 9% of those developing countries GDP per annum on average. Yet, according to World Bank data, only about half of the required amount of over U.S. $1 trillion per year is spent on infrastructure investment and maintenance.

The current staggering infrastructure needs in the EM markets represent a truly historic opportunity to provide an estimated 884 million people with access to safe water and also offer billions of others the use of electricity, improved sanitation and other services. This is happening as EM governments not only increase spending on infrastructure, but also have taken steps to increase regulatory oversight of such projects. However, most EM countries still need both outside capital and outside expertise.

Building Cities, Supporting Rural Areas
According to the World Bank, in 1950 only 30% of the world’s population lived in cities. This year, for the first time in history, a majority of the world’s population lives in urban centers. By 2030, this figure is expected to reach 65%. Cities will need to absorb another 2 billion people over the coming 20 years, and 90% of this urban expansion is expected to take place in the emerging world.

This demographic challenge will give rise to unprecedented demands for investments in infrastructure in thousands of cities and towns.  Further, in order to limit the urban migration, infrastructure spending will need to create adequate growth and income opportunities in rural areas. These investments should improve the market linkages from the rural regions of the country to the urban areas, where the bulk of domestic consumption takes place. Further preventing the urban explosion will mean investing in manufacturing and service-delivery capacity in regions further removed from today’s urban core.

Why PIMCO Likes This Asset Class
For EM nations to nurture the domestic demand needed to continue growing, they will have to invest in transportation, energy, telecom, water and sewage and affordable housing. Infrastructure is a structural element of every economy allowing for the production of goods and services, enabling mobility of labor and reducing time and costs of production and delivery of products to the market. Telecom facilitates communication. Roads are needed to transport raw materials and finished good. Factories need a reliable source of energy/power in order to maximize capacity. Lack of such infrastructure is an obstacle to both social and economic development.

EM countries must develop infrastructure in order to ensure their population does not lose out on the increased growth opportunities of globalization.

The market dynamic has significantly improved, as demand for infrastructure spending is increasingly supported both by strong population and economic growth and by increasing urbanization. The opportunity in infrastructure investing is also enhanced by increased government commitment to infrastructure development, which is occurring alongside increased activity in the private sector and the development of local capital markets. Estimates of required infrastructure spending in the EM over the next three years exceed US $2.25 trillion.

One positive trend is that government officials, having benefited from work with multinational companies and providers, are recognizing the need to become more investor friendly. Indeed, some government and multilateral/development banks are playing a prominent role in attracting private-sector investors, although each market presents its own peculiarities.  So while it is clear that the public sector will continue to play a key role in delivering infrastructure services, increased participation from private investors -- such as in private public partnerships or privately operated concessions -- will be essential in addressing the growing infrastructure finance needs in developing countries. 

Additionally, while banks over the last decade had been aggressively and affordably financing infrastructure projects, the global financial crisis has eroded some of this largesse. This in turn has created an opportunity for other investors, including bond investors, to step in and provide financing.

We believe infrastructure remains an important secular driver of growth for EM. Sovereigns have substituted public investment to counter the lower trade flows and committed budgetary resources to stimulate their economies. Infrastructure has been and will be an important component of this fiscal stimulus. 

PIMCO Approach to Opportunities in EM Infrastructure
As emerging country governments seek to utilize the fiscal credibility they have built over the past decade to preserve growth amidst a global recession, their fiscal stimulus measures have been largely directed at infrastructure, and this suggests that the EM infrastructure investment strategies may benefit further from cyclical forces currently at work in EM. Strategically, the characteristics of EM infrastructure bonds complement traditional asset classes in alpha generation, while providing the additional benefit of portfolio diversification. There are two ways PIMCO approaches investing in EM infrastructure.

One strategy for investing in  emerging markets and infrastructure bonds seeks to take advantage of the secular factors cited above, but does not invest via local currencies and is viewed as a tactical investment, both for core total return type bond portfolios and dedicated EM accounts.

Ultimately, our objective is to provide returns in excess of the JPMorgan Corporate Emerging Markets Bond Index Diversified (the so-called CEMBI Diversified). The primary investment guidelines of this strategy provide for exposure to the infrastructure subset of the CEMBID in a diversified manner across geographic regions and sectors. The CEMBI Diversified captures a broad arena of U.S. Dollar-denominated EM corporates in 19 countries, that includes the banking, consumer products, industrial, metals and mining, oil, telecom, and utilities sectors.

In contrast to the CEMBI Diversified, which has large exposure to the riskier banking and consumer sectors, PIMCO prefers a broadly defined infrastructure subset of corporate and quasi-sovereign issuers.

Another approach is investing in emerging markets and infrastructure using a local bond strategy. The aim is to capitalize on all the secular factors supporting EM local fixed income markets -– their rising contribution to global economic activity, improving creditworthiness and potential and their potential for currency appreciation – by investing in local debentures, project finance, securitization deals, and public/private utility and housing companies. The strategy may also invest in so-called “greenfield” projects with implicit/complicit government support to build new telecom networks and “brownfield projects” to redevelop former industries sites, among other projects. The focus is on local currencies and local markets which, investors need to realize are sometimes illiquid.

This approach may lead to an investment portfolio that exhibits a higher quality bias with a minimal, if any, give up in return potential, all with the expectation of lower volatility.

How PIMCO Will Perform This Asset Analysis
The Emerging Markets and Infrastructure Strategy unites two of PIMCO’s core competencies: EM research and credit research. The investment philosophy of both places primary importance on avoiding credit events. First, the PIMCO emerging markets team will undertake in-depth fundamental sovereign research analysis. Then our credit research team will analyze in-depth the infrastructure sectors and individual issuers to identify the most compelling opportunities.

PIMCO’s existing EM strategies already make extensive use of infrastructure opportunities and in some sense, the Emerging Markets and Infrastructure Strategy can be regarded as a concentrated exposure to the corporate and quasi-sovereign positions we hold across the flagship external debt products. The firm currently holds approximately $15 billion of these assets in existing portfolios.

The Potential Benefits of Investing in Infrastructure
Over time, this government support tends to result in generally lower levels of volatility in these priority sectors relative to other, less strategic or volatility-prone sectors while also supporting return potential. Put differently, the infrastructure subset of EM corporate bonds currently offers an improved risk-return basket of opportunities. For instance, the metals and oil sectors, which include a number of world class operators who collectively generate large foreign exchange earnings, make sizable contributions to state tax revenues and employ significant numbers of citizens. Given their systemic importance, we have observed numerous instances of sovereigns lending support to these types of companies in times of market stress.

Simply put, focusing on infrastructure may enable investors to access potentially the most appealing portion of the non-sovereign EM universe. While there is a qualitative underpinning to this statement, the behavior of the emerging corporate market helps to validate this proposition.

The chart below shows the total U.S. dollar total return for the J PMorgan EMBIG and the JPMorgan CEMBI over the latest three-year and five-year periods and since inception, and also identifies the credit quality of the index for each respective period. PIMCO strategies would aim not only to outperform the index but to maintain a higher credit quality.

Conclusion
Fundamental improvements that have taken place over the past 15 years, including floating exchange rate regimes, sustainable fiscal dynamics, lower inflation, larger pools of domestic savings and stronger external reserves, have facilitated improvements in EM countries. This can be readily observed in the positive ratings migration for several emerging countries.

In the 1990s, investments represented only 24% of EM GDP, and this investment was critical to improving productivity and growth potential. Currently this figure is close to 32%. Most of these investments have been undertaken by the private sector.

In the future, continued investment – particularly in areas classified as infrastructure – will in our opinion be a prerequisite for EM countries to shift to a sustainably higher growth rate.

Therefore, we believe, now is an opportune time to focus on infrastructure, since it allows us to effectively leverage the sovereign balance sheet while potentially enhancing the return profile of a portfolio.

To the extent that sovereigns recognize that this shift is important and move to proactively support infrastructure sectors, this offers an opportunity for our investors to capitalize on the higher yields generally associated with non-sovereign obligations while retaining some measure of support for such assets from the sovereign. 

PIMCO focuses on entities involved in economic sectors deemed of critical importance to the sovereign, such as energy, transport, telecom, policy housing, and water and sewage.

The importance of these sectors is shown by governments typically having a full or partial ownership stake of companies related directly in infrastructure sectors. In other cases, such entities address a structural shortage that the government has identified as critical to the maintenance of financial, social, or political stability within a country.

There may be cases in which there is not an implicit sovereign guarantee; however, there is a reasonable basis to expect that the sovereign may extend support in times of market distress.

PIMCO’s existing EM strategies already make extensive use of infrastructure opportunities and in some sense, investing in emerging markets infrastructure can be regarded as a concentrated exposure to the corporate and quasi-sovereign positions we hold across the flagship external debt products.