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Supplements » EM Report 2011

LOCAL CURRENCY BONDS: Will it be different this time?

Currency-bondsWith low interest rates in the developed world, poor economic growth and lingering fears of an unstable dollar, is it any wonder that investors are turning to local currency bonds, again, to increase yields, asks George Mitton

In the wake of the financial crisis, fixed-income investors have ventured into previously unknown territory. Deterred by dollar fears and Europe’s debt crisis, they have crossed borders and begun pouring money into the rapidly expanding market for local currency bonds.

A few years ago it was only small scale and speculative investors doing this. Local currency debt, especially that issued by emerging markets, was a new and unexplored asset class.

But in the last 18 months this has changed, says Rob Stewart, a specialist in JP Morgan Asset Management’s fixed income team. “For the first time we’re starting to see pension plan and insurance flows start to predominate,” he says.

These institutional investors are attracted to local currency bonds because they offer diversification against variations in the dollar or euro. But there is another attribute that is appealing in light of low interest rates and poor growth in the United States and Europe: high yield. The JP Morgan Government Bond Index Emerging Markets (GBI-EM) indices, which track local currency bonds issued by emerging market governments, are on average rated as investment grade, yet still offer a 7% yield on average.

Stewart believes interest in emerging market debt is only just beginning. “We’re only at the tip of the iceberg in terms of interest in the UK and the US,” he says. “I strongly believe emerging market debt will become a core, strategic part of an asset allocation framework.”

But if this asset class is so attractive, why has it taken so long for investors to pursue it, and why are inflows still so much lower than, say, emerging market equities?

One reason is that local currency debt is a relatively new asset class. The GBI-EM index was only launched in 2005 for instance.

Another reason is investors are wary. A string of emerging market crises are within living investor memory: the 2002 Argentinian default, the 1998 Russian default and the Asian currency crisis of 1997, to name just three. These events caused great volatility and disruption.
It is not that the risk of another crisis has disappeared. However, there is a growing sense that emerging markets have learnt from previous shocks and improved fiscal discipline via their central banks.

Jerome Booth, head of research at investment manager Ashmore, believes the central banks are more competent than ever. He argues that their efforts to enforce monetary policy are the most important dynamics in the market and notes that by juggling interest rates and exchange rates, the central banks are behind most of the major changes in currency prices. This is where investors should look for returns, he says.

“The big source of return is currency movement,” says Booth. “And the alpha potential is very large at the moment.”

Booth says that by monitoring the activities of a range of central banks, investors can take informed positions on shifting currency rates in emerging markets. He adds that specialist investment advice can help with the complexity and scale of the job, and help investors avoid risk.

In fact, the opportunity of local currency bonds is so great that, in Booth’s words, it is nothing but prejudice that prevents investors embracing this asset class.

“People have a very biased view of the world,” he says. “They see emerging markets as somehow peripheral and small, but they’re not. They’re half the planet.”

For most investors, local currency bonds offer more than just an opportunity for arbitrage, though. There is a bigger gamble at work; a bet that emerging market currencies, as a bloc, will appreciate relative to the dollar and the euro.

For those that buy the wider emerging market story, this is a sound assumption. Emerging markets have what analysts call “strong fundamentals” – they are displaying strong economic performance and have debt levels, relative to GDP, that are far below those of developed countries.

Strength and sovereign wealth
Importantly, these economies are much stronger today than they were ten or 20 years ago, when the worst of the emerging market crises hit. For many investors, this leads to a simple conclusion: local currency bonds are less risky than in the past.

Enthusiasm about emerging market debt is so widespread that some investors believe it to be a safer asset class than investments in dollars or euros. Sovereign wealth funds in emerging markets are particularly keen buyers of local currency bonds because they fear a dollar collapse and a subsequent depression in the US and Europe. In this case, buying debt from emerging markets that are large and closed is a good strategy, for instance Brazil, India and Indonesia.

All this amounts to a reversal of received wisdom, according to Booth: “People turn round and say, if I’m risk averse I have to sell emerging markets. It doesn’t add up. If you’re risk averse you need to be in these markets.”

The sceptical view
However, not everyone believes in the superiority of emerging market currencies. According to Peter Baum, portfolio manager at Glendevon King Asset Management, investors in this asset class should look to safer currencies such as Australian dollars, Canadian dollars and the Norwegian kroner.

He points out that these countries are governed by mature, stable democracies, with small and comparatively skilled populations. They have natural resources that will be a source of profit if the world economy grows, but would also be seen as safe havens if the economy stalls.

They also offer high yields. Australian dollar bonds from double and triple-A rated issuers are giving yields of up to 6.5% for maturities between now and 2015. Baum remarks that if you offered these rates to investors in dollars or sterling “they would bite your hands off”.

These yields are on a par with bonds from lower-rated issuers in countries such as Brazil, Russia, India and China (the Brics), essentially meaning investors are getting the same deal with less risk. Of course, avoiding these emerging markets means investors would miss out if their currencies appreciated dramatically. But Baum challenges the popular view and claims this won’t happen.

“I think the Brics have been over-hyped and I don’t see any value there whatsoever. I actually see those currencies decreasing against the dollar,” he says.

Practical investing
Most reliable sources believe the market for local currency bonds will grow quickly in the next few years. Global consultancy Mercer says 22% of European pension funds intend to increase their allocation to emerging market debt. These gains will most likely come at the expense of dollar-denominated debt and European sovereign debt. This is no surprise given that several emerging market countries are now deemed to be less risky borrowers than some western European countries.

Pension funds will need to ask how much they should devote to this asset class. According to Stewart at JP Morgan: 3% to 4% of their allocation. Though it could take many pension funds three to four years to move on this advice, the effects could be impressive. “If you look at that as a percentage of just the US market, that could be a very significant number,” he says.

Stewart likes the Asian currencies and takes a basket approach that includes long positions in  China, Malaysia, Korea and Indonesia.

He also pursues tactical plays with short positions on some Eastern European countries such as Poland.

It seems likely that the main source of return for active managers will continue to be currency movement, as Jeff Keen, manager of the Waverton Global Bond Fund at JO Hambro Investment Management, explains: “By far the biggest driver of buying local currency bonds in Asia or Latin America is for a currency reason.”

He allocates about 40% of his portfolio to Asian currencies. However he echoes the cautious approach of Peter Baum by allocating the rest to safer currencies from Norway, Sweden, Canada and Australia.

Of course, it may be a bumpy ride. In fact, for local currency bonds from emerging markets, it is sure to be. However, there will be no shortage of issuers as sovereign borrowers seeking to protect themselves against fluctuations in the dollar are joined by an every-growing pool of corporate borrowers in emerging markets.

As the market matures, demand is sure to grow and this newly discovered asset class will become more trusted.

©2011 funds europe