Emerging bonds in local currency remain attractive

History seems to be repeating itself in Argentina. After the crisis of Summer 2018, Argentina's markets were rocked again last week following a poll on the upcoming presidential election on 27 October. The incumbent, Mauricio Macri, is losing ground because of the country's economic situation. The markets fear the return of the former president, Cristina Fernandez de Kirchner, whose popularity is growing in the polls. Furthermore, they consider her to be partly responsible for the current economic situation. Rampant inflation has reached 55% and the country faces a second recession under the Macri presidency.

The peso has depreciated further, which could result in even higher anticipated inflation. Bond yields have risen, pushing yield spreads with US Treasuries to 900 basis points (9%), close to the critical threshold of 1,000 basis points (10%). The emblematic 100-year bond issued in 2017 is trading at only 68% of its issue value.

Although the situation appears to have stabilised thanks to central bank intervention, investors fear another default on sovereign debt. They estimate a 60% likelihood this will happen within the next five years. In general, countries in turmoil prefer to default on their dollar-denominated debt, rather than on their local currency debt. This choice reflects a desire to avoid a revolt of the population as local currency debt is more often held by the country's residents, as opposed to dollar-denominated debt, which is usually in the hands of international investors.

We need to look more closely at the composition of the benchmark indices (JP Morgan) to analyse the impact. Argentina is a major issuer of dollar-denominated debt and accounts for 10% of this index, while it has a mere 0.5% representation in the debt index in local currency.  Moreover, the countries with weak fundamentals (Argentina, Turkey and Venezuela) account for 24% of the Emerging Market debt index in dollars, so we decided not to adopt a positive view on this asset class at a time when the US Federal Reserve was announcing a shift in monetary policy towards the end of its restrictive policy.

We therefore prefer Emerging Market local currency debt. With the example of Argentina, we should not forget that growth in emerging countries is higher on average than in developed countries: 5.9% versus 2.2% in 2018. For 2019 and 2020, we forecast stable growth of 5.8% in emerging countries, while we see it drop to 1.5% and then to 1.3% in developed countries.

As for inflation, we expect it to remain contained in emerging countries: 2.5% in 2019, 2.8% in 2020, compared with 2.6% in 2018. Argentina, at 55%, is the exception, as is Turkey to a lesser extent. The other countries in the EM local currency index posted inflation below 5% in 2018, with a favourable outlook. This trend should encourage the central banks of the countries concerned to maintain a stable policy (or even become more lax), thereby capping a potential rise in bond yields.

As well as being able to capture a possible fall in yields, local currency debt has another potential source of income, albeit volatile: the exchange rate. Indeed, the evolution of a local currency bond depends very much on the foreign currency, especially as the currency component has an impact on performance. In our view, the dollar is likely to depreciate in the medium term, as US growth is slowing and the US Federal Reserve is at the end of its monetary tightening cycle. Moreover, the dollar now looks overvalued. If this scenario materialises and the dollar weakens, Emerging Market currencies should appreciate, which is good news for euro and dollar investors.

That said, carry remains the main attraction of EM bonds in local currency.  The Yield to Maturity (6.2%) is much higher than that of sovereign bonds issued by developed countries. For example, 0.1% in Germany, 1.2% in Spain, 2.5% in Italy and 2.6% in the United States. The high yield serves as a buffer against adverse movements in interest rates and currencies.

Finally, diversification. Many portfolios are exposed to only one or two currencies and the Markowitz-efficient portfolio theory is forgotten, which suggests that diversification can reduce the risk level of a portfolio with the same expected return. Local currency bonds play their full role here, as the benchmark index comprises around 20 currencies.