Local currency debt in focus

May 4, 2018
By Laurent Develay

Improving fundamentals and yields that on average surpass those of U.S. high yield bonds have helped to put local currency emerging market debt in the spotlight for investors looking to add potential returns and diversification, particularly away from U.S. dollar exposure. The opportunity set in local currency debt also is expanding in terms of breadth, depth and liquidity. And with the expectations that China may be added to major global bond benchmarks including the JPMorgan GBI-EM Global Diversified Index, we believe local EMD may start to play a more meaningful role in many investors’ portfolios.

However, taking advantage of the opportunities in local debt presents a unique set of challenges. Relative to hard currency debt, which is primarily driven by duration risk, local currency emerging market debt is dominated by FX, with duration as a secondary but still important source of return. These two sources of return add alpha potential, but also make local debt more complex and nuanced to manage.

Laurent Develay, Portfolio Manager and Head of Emerging Markets Local Debt, explains why local currency debt may help investors meet certain goals, if they can manage the risks.

Historically, EM debt was more of a hard currency story. What’s the case for a long-term allocation to local currency bonds?

We have been shifting from a world in which emerging economies were borrowing in dollars to a world in which they’re borrowing in their own local currencies as well as in dollars. This has helped stabilize emerging economies, and their debt. As countries issue more bonds in their domestic currencies to support growth, they become less sensitive to the currency mismatch risk that comes with borrowing in dollars.

This transition allows investors to access an asset class that is more liquid and has the potential to deliver higher yield (See the chart below) and diversification compared to developed market government and high yield bonds. Something else that is quite interesting to mention here is the potential inclusion of China in the JP Morgan GBI-EM Global Diversified Index.

Spreading further

Yields for local currency EMD, U.S. Treasuries, German Bunds and U.S. high yield

Spreading further

Source: Bloomberg, April 2018. Yields for 10Y U.S. Treasuries, 10Y German Bund and 10Y China are based on respective generic government bond indices. Data for U.S. high yield data are based on Bloomberg Barclays U.S. High Yield TR Index Value Unhedged. USD and local currency emerging market bonds are based on JPMorgan GBI-EM Global Diversified Composite Unhedged USD. Past performance is no guarantee of future results. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index.

How will the inclusion of China affect global investors?

The majority of Chinese bonds is traded onshore and currently not easily accessible to global investors. China’s bond market is opening up but this is happening gradually, mirroring the path of liberalisation for its equity markets. For example, MSCI decided to add China A-shares to its Emerging Markets and ACWI indices after four consecutive years of review. In comparison, China has been under review for inclusion in the JPMorgan GBI-EM Global Diversified Index since 2016. 

Issues such as capital controls remain a concern, though China’s inclusion eventually could serve as a model for other emerging market economies to liberalise their market to foreign investors. China is the world’s second largest economy (World Bank Apr.19, 2018) and the world’s third largest bond market behind the U.S. and Japan (Bloomberg, Feb. 2018). Its accession will mark the most important addition to the JPMorgan GBI-EM Global Diversified Index since launching in 2002. Over time, China’s inclusion to major indices potentially could double the size of the investable universe, and so, significantly increase the liquidity of the benchmarks.

Returns in local currency bonds are driven by both currency risk and rate risk. What is your approach to managing them?

We completely segregate the currency risk from the rate risk in our investment process. Traditionally, investors might decide to buy a bond, then layer a currency position on top of that. We don’t believe in that model, because in our opinion, the bond you’re buying is running currency risk. When you’re buying a Brazilian bond, you’re buying the local interest rates, and you’re also buying the Brazilian currency.

The two main sources of alpha in our portfolios—FX and rates—are supported by different factors and require different skillsets to manage on a day-to-day basis. Therefore, we believe it’s actually better to have two different managers independently making those investment decisions.

FX is impacted by both local and global factors. How do you manage the interplay between the two?

It’s a matter of trying to understand the most important factors driving performance at any given point in time. Are we in a world more driven by global factors, or are we in a world that is much more idiosyncratic and therefore driven by local stories?

That’s why we focus on investment themes. Some investment themes are going to be more oriented towards global factors. If we have enough of an indication that global factors are likely to dominate markets, we would recalibrate our baskets of government bonds and currencies accordingly. At other times, we’re going to be much more driven by local, idiosyncratic drivers and our baskets would reflect those views.

Although local currency debt comes with attractive income potential, many investors can’t stomach the volatility. How do you address this?

Volatility is part of the nature of the asset class, and that is why investors have historically demanded higher yields from local currency debt compared to hard currency debt.

While volatility can be extreme, it can also present opportunities. This happened in Brazil last year, when President Michel Temer was targeted in a bribery investigation. In May 2017, the Brazilian real fell about 9% against the U.S. dollar in less than two days, but subsequently recovered all of its losses within about four months of the sell-off, according to Bloomberg data.  So if you took the view that the currency overreacted to negative news, you had the opportunity to add some alpha to a portfolio.

This event also highlights why you need a process in place to manage short-term volatility. Having a risk management process that can help inform what you need to do when a risk scenario transpires can put you in a better position to defend your portfolio.

Along with volatility, another concern that we hear from clients is contagion risk. However, over the last two or three years, when we’ve seen a significant volatility event driven by country-specific idiosyncratic risk, what happened in those countries has tended to stay in those countries. There has been little contagion from one country to the whole asset class.

This wasn’t necessarily the case historically. For example, during the Russian financial crisis in 1998 we saw widespread effects across many emerging markets. I think that in today’s climate idiosyncratic events may present more relative value opportunities and less chance of contagion risk.

Some investors are concerned about the impact of interest rate normalization. What are the risks?

As long as the pace of the rate increases is gradual, which we expect it to be, we are not overly concerned. The other related issue for investors is how the dollar will respond in this environment. We think there is scope for higher dollar volatility. If a spike in the dollar causes an EMD sell-off, emerging countries could face liquidity contractions, making their funding situations more complicated. We believe that we are far from this situation at the moment because fundamentals remain supportive. But this is something we are monitoring through our risk scenario analysis.

Where do you see opportunities today?

We favor currencies that are less correlated to U.S. monetary policy and the dollar. Any interest rate hikes will impact specific emerging markets very differently, depending on idiosyncratic factors such as economic growth, capital inflows and local monetary policies.

We also like some frontier markets, and we have off-benchmark positions in those countries, but position sizing needs to be adapted to the often more challenging liquidity conditions of frontier markets. 

Laurent Develay
Head of Emerging Markets Local Debt