Local currency bonds good to grow

5 July 2010 | By Nick Rice

Developed-world institutions still need income for their ageing baby-boomers, but after the financial crisis they will probably lend less to the overleveraged developed world and more to the underleveraged developing markets.

Although emerging markets still issue plenty of dollar-denominated debt, the main opportunity now resides in local currency bonds. As developing markets strengthen financially and boost their consumption, the argument runs, their local currencies should appre­ciate and thus hedge against inflation.

Buyers of local currency debt will also avoid one of the risks that have haunted them since the Asia ­crisis of 1997-8: that an emerging market will ­falter, its local currency will devalue and its ability to repay its debt in hard currency will weaken. (article continues below)

The total emerging market debt universe is already gargantuan, with almost $300 billion (£200 billion) in issuance in the first half of this year alone, according to Thomson Reuters. Although the local currency market is huge, it is relatively illiquid and young as an investment, which risks instability but also means investors can buy in at low valuations.

John Stopford, a co-head of fixed income at Investec Asset Management, and Bob Michele, the global chief investment officer for fixed income at JPMorgan Asset Management, both approve of JPMorgan’s estimate that five sixths of emerging market debt is denominated in local currency, but four fifths of investments in the asset class are made in hard equivalents. But both see, in Stopford’s words, a “pretty significant shift in buyer ­interest”.

 

“Emerging market debt, and particularly local currency debt, wasn’t a core holding for many clients until recently, but that’s changing,” Stopford says. “We’re seeing pension consultants and actuarial consultants recommend it because of its risk/return characteristics. It’s the fastest growth in net flows we’ve seen in history. People are seeing opportunities against developed markets, including retail buyers.”

According to Michele, this is particularly true for the darling of emerging markets, Asia. “Most of Asia is in a sweet spot for being a sovereign borrower. In the developed markets you’re going to wrestle continually with how they get the debt burden mitigated. That can’t be positive near-term for currency. Growth in Asia is still pretty firm, and they enjoy current account surpluses. You are going to get this upward drift in currencies.”

Although sovereign bonds are still the most liquid opportunity in local currency emerging market debt, Stopford and Michele point to potential interest in local currency corporate debt. Both observe, however, that the increased local currency weightings in their portfolios come mainly from governments.

As Stopford hints, there are so many local emerging market currencies and governments that sovereign debt already offers a good deal of diversification and hedging against volatility, although Michele already sees substantial demand for the emerging market corporate bond universe as a whole.

As with any investment, local-currency emerging market debt is not risk-free. Michele notes that the associated derivatives markets and hedging mechanisms could still develop further. Stopford says the markets could be more liquid. Some swift arbitrage could always arise between hard and local-currency debt and reduce the risk premium on the latter. But as Stopford points out, the dollar-denominated markets are already yesterday’s story. With local currencies, investors have a long-term shot at growth.