Emerging Bonds In Local Currency
Although the currency risk is high, emerging bonds in local currency offer good opportunities
Emerging bonds in local currency started the year on a high note as global growth accelerated before correcting as of mid-April. Their performance has since been wiped out. In dollar terms, emerging market bonds have recorded a negative performance of 5.6% year-to-date. In euros, the return is -3.5%. The impact of exchange rate movements is therefore far from neutral.
Causes of the recent fall
The causes are multiple. The soaring dollar, +6% for the dollar index since mid-April, caused a sell-off of emerging assets as investors worry about currency losses. At the same time, some investors wanted to take advantage of the rise in US rates (the 10-year yield hit a high of 3.10% in May) to buy US sovereign bonds at attractive yields and they are much less risky than emerging bonds. The resolve for more protectionism in the US and rising trade tensions also scared the market, which triggered a sale of risky assets. The markets initially focused on the most fragile countries, fuelling fears of a domino effect.
Some countries were hit harder than others. Argentina and Turkey, for example, experienced a currency crisis in April and May. Both are more vulnerable because they have twin deficits: government deficit and current account deficit. Their currencies collapsed against the dollar and the euro. The Central Bank of Argentina even had to raise its policy rate to 40% and reach a deal with the International Monetary Fund to prevent a massive flight of capital. Argentina's weight in the emerging index is marginal (0.8%). Conversely Turkey accounts for 6.6% of the index.
The emerging currency index is close to its historical low. Some emerging currencies that were under pressure, such as the Turkish lira, Russian rouble and Argentine peso, have stabilised or even appreciated, heralding a lull.
Spreads between local debt and US rates of equivalent duration, which had risen sharply from 330bps to 400bps, have stabilised in recent days. The same phenomenon can be observed in sovereign CDS, which are insurance contracts against the risk of default by an issuer.
Protectionist risk has affected risk appetite. This risk could diminish within a few months because Trump is keen to appease trade tensions between the US and China/Europe ahead of the US mid-term elections on 6 November by communicating about rising equity markets. Global growth should also contribute to a spread compression.
Looking at fundamentals, emerging countries are stronger than before. Their improved current account balance has reduced external financing needs, limiting exposure to a stronger dollar or higher US bond yields more than before. In terms of projections, we do not see the dollar continuing to appreciate over the next 12 months. We only anticipate a moderate rise in US rates, which should support the asset class going forward.
Turning to central banks, some countries (e.g. Argentina, Turkey, Indonesia) have been forced to raise rates to stabilise their currencies but most show moderate inflation, which is limiting the risk of a rate hike. Once currencies have stabilized, some countries may consider cutting rates.
Emerging bonds in the local currency index offer an attractive yield of 6.6% and a positive inflation-adjusted yield of 2.7%.
In short, we are positive on emerging debt in local currency, believing that it should outperform sovereign bonds in developed countries. We see value in this asset class and believe that an emerging pocket makes sense in an investment portfolio, if only for diversification purposes.
The asset class will be clearly penalised in the event of more protectionism in the US and an escalation in the trade war, because capital flows to emerging countries are dependent on risk appetite.
Emerging debt in local currency is heavily impacted by exchange rate fluctuations. Another surge in the dollar would trigger a sell-off and reallocations of capital from emerging to developed countries.