This article is part of Your Guide to Emerging Markets. All this week, we are focusing on emerging markets, sharing their potential pitfalls – and where you can make a pretty penny.
With developed market Government bonds currently looking pretty unattractive, with low or negative yields, fixed income investors have been forced to look elsewhere.
Local currency emerging market debt became the area of choice for many, and investors were rewarded handsomely, with the benchmark JPM GBI-EM Global Diversified Index returning 38% to pound sterling investors through 2016 and 2017. That compares favourably with the hard currency version, which was up 20%.
Investors piled into the sector, with Europe-domiciled ETFs in the Global Emerging Market Bond Local Currency category seeing inflows of €4 billion in 2017 alone.
However, with the US dollar strengthening, appetite has waned. In the past three months, €1 billion has been pulled from those funds in March, April and May of this year.
The local currency index is down 4% year-to-date, though that still compares favourably with the hard currency index at -5.8%.
“As soon as the dollar goes up investors in EM start shuddering and they start selling,” says Jan Dehn, global head of research at Ashmore.
While he accepts there’s reasons for taking profits, “because when you make 15% [in US dollars] in one year in local bonds you’re running ahead of schedule”, Dehn reckons there’s further to run, though future returns will be lower.
The Pros and Cons of Emerging Market Debt
So, should you continue to look towards local currency emerging market debt, or rotate into hard currency bonds?
The first thing to consider according to Matthias Palowski, associate portfolio manager at Morningstar Investment Management is that, while both may be lumped together as they share the same ‘emerging markets’ moniker, the asset classes are completely different.
The local currency index is very concentrated and is dominated by the larger economies like Mexico, Brazil, Turkey and South Africa. “If you follow the news flow on those countries, we have Trump issues, currency and inflation issues, political issues,” says Palowski. “That basket got beaten up quite a bit on esoteric news flow.”
The hard currency basket is much more diversified, with smaller weights assigned to each country. “That’s because countries like Ivory Coast and Kenya can’t issue debt in their own currencies because no one will buy it, so they have to sell hard currency.”
The dollar’s advance will have an impact on the outlook for the assets, but shouldn’t affect UK investors as much, says Palowski. If countries generate their revenues in their local currency but have to pay their debtors in US dollars, then it becomes harder for them to service that debt.
Why Hedging is Important
For retail investors in the UK, though, when buying a hard currency emerging markets debt product, you would hedge it into sterling. Palowski does not recommend using an unhedged product “because you have a two-way bet – a dollar position as a pound investor and an EMD hard position”.
Similar comments apply to local currency debt, in that it should be hedged, though clearly you carry currency risk by investing. With the dollar appreciating, it follows that the basket of currencies will devalue. Palowski reckons the currency basket is around fair value currently, but it can deviate a lot.
Overall, Palowski says hard currency debt is attractive on a relative basis, against a fixed income universe that’s quite overvalued in general, but on an absolute basis “it’s not a bargain yet”.
On the other hand, Morningstar Investment Management reckons local currency emerging market debt “is one of the least overvalued fixed income asset classes”. The main reason for this is the attractive level of real yields available.
While inflation in countries like Brazil and South Africa is high compared with developed markets, it has been much higher historically. And yields on emerging market debt are high, with real yields – the yield minus inflation – around the 3% level.
Compare that with the UK, where Gilts are yielding 1.5% and inflation is running at 2.4%, giving a negative real yield. “Fixed income theory suggests that markets with high real yields outperform markets with low real yields.”
How to Access Local Currency Emerging Market Debt
It has only been possible to invest in emerging market fixed income in a passive format for a short amount of time due to index complexities.
However, it seems a good way to go. “I haven’t seen many fund managers in the emerging market debt space bar a couple that have proven themselves to perform better than markets,” says Palowski.
He would favour funds that specifically target local currency and hard currency bonds, rather than funds that combine the two. “There are completely different fundamental drivers and analysis you’ve got to undertake. There are funds that are blended, but we wouldn’t recommend that.”
Morningstar analysts rate two local currency ETFs highly, both of which have Silver Ratings. They are iShares JPMorgan EM Local Government Bond (IEML) and SPDR Bloomberg Barclays Emerging Markets Local Bond (EMDD).
One active open-end fund that Morningstar rate as Bronze is GAM Multibond Local Emerging Bond, run since 2000 by Paul McNamara.
