A combination of looming US interest rate hikes, sliding commodity prices and jaded growth prospects are heaping pressure on emerging market local currency bonds. Leading fund managers are questioning the merits of investing in large pockets of local currency bonds after years of poor returns look set to worsen, with no reprieve expected for at least another 18 months.
Investors are increasingly wary as renewed currency wobbles have depressed returns further.
“Increasingly, local currency is not seen as a pure standalone investment,” said Zsolt Papp, global head of emerging market debt client portfolio strategies at JP Morgan Asset Management.
JP Morgan’s GBI-EM Global Diversified, which measures the performance of local currency bonds, is down 7.4% for the year up to July 28 in US dollar terms.
By contrast, the EMBI Global Diversified, which tracks emerging markets sovereign hard currency bonds, is up 1.4% over the same period, while the CEMBI Broad Diversified, which measures emerging markets corporate hard currency debt, has returned 3.5%.
The poor performance of the local currency index is not isolated to this year. Investors have earned a return of just 5.41% through the GBI-EM index since January 1 2010. The EMBI Global is up 45.6% over the same period, while the CEMBI Broad has delivered a total return of 43.26%.
“A simple EM FX appreciation strategy has not been valid for the past five years,” said Papp, who also said that the best way to invest in local currency debt was either as part of a tactical asset allocation strategy or through blended funds.
Blinded by the yield
When the historical data are so stark, why have investors been tempted into local currency bonds?
“They pay a much higher yield,” said Jan Dehn, head of research at Ashmore, which has long pointed to opportunities in local currency debt.
Russia’s rouble May 2030s, for example, were yielding 17.5% on Friday, according to Thomson Reuters Eikon. The sovereign’s dollar 2030s were, at the same time, yielding 3.65%.
But emerging market currencies have taken a hammering from the money-printing efforts of developed market central banks.
“There have been trillions of dollars created that are exclusively being used to buy developed market assets,” said Dehn. “Not a single QE has bought emerging market assets.”
Emerging market currencies are scraping along at multi-year lows, with the Turkish lira the weakest it has been against the dollar in 20 years at 2.7669 on Thursday morning.
The Brazilian Real is at R$3.3283 to the US dollar, a 12-year low, while the Russian rouble, at Rbs59 on Thursday, is 53% weaker than it was 10 years ago.
One fear is that a hawkish US Federal Reserve could compound dollar strength, piling further pressure on emerging markets’ currencies, especially for countries that are commodity exporters or have gaping current account deficits.
But Dehn said that at least by pulling the trigger, the Fed will stop the market from fretting about when the rates cycle will turn.
“A rate hike will stop the hyper-volatility and uncertainty around the timing of the hike,” said Dehn. “It will be positive for credit, including emerging markets.”
Opportunities remain
Longer-term Dehn thinks inflation is likely to pick up in the US at the tail-end of 2016, which will ease dollar/emerging markets FX pressures, all else being equal.
“On that metric, we should be on the back foot in emerging market currencies for another year and a half,” said Dehn. “I do not imagine that lots of investors are going to take an outright position on EM FX – we haven’t – but there is an argument for cautiously going into local currency bonds.”
It is not all bad news for local currency debt. Investors in Asian bonds, which tend to benchmark against the weak euro, have done better than their Central and Eastern Europe, Middle East and Africa and Latin America-focused peers.
“This year, Asian local currency markets are very slightly down, but still outperforming the G10 and broader emerging markets,” said Kenneth Akintewe, senior investment manager on Aberdeen Asset Management’s Asian fixed-income team.
Asian currency volatility is relatively modest at an average of about 8%; within that the renminbi is around 2% and the Malaysian ringgit above 10%. In emerging markets such as Latin America, currency volatility can be 15%–20%.
“Despite the volatility in equity markets, China’s bonds and currency will likely continue to outperform the broader EM markets as sentiment remains fragile and volatility high, providing one of the better allocations,” said Akintewe.
