At a time when many bond investors vacillate between concerns over rising interest rates and the belief that the multi-decade bull market in fixed income is not over yet, emerging local currency debt deserves to be given more attention than it often gets these days. Or so argue Bryan Carter and JC Sambor, head and deputy head of emerging market debt, respectively.
Local currency debt: under-appreciated, so under-owned?
In part, the cold shoulder for local currency debt reflects an underappreciation of the size of the asset class and the opportunities it offers. It has become one of the largest fixed-income universes over the past eight years, with local currency debt issued by emerging market governments rising to USD 8 trillion by January 2018 and corporate debt in local currencies exceeding USD 7.6 trillion.
The asset class has become deeper, with market liquidity improving, and broader, with more countries now issuing debt as well as more EM corporates. This has expanded the range of investment opportunities, also in high-quality, investment-grade debt.
The bad rap can also be attributed to the perception among certain investors that local currency bonds tend to be very volatile. This is indeed a perception. The reality is that historically, the volatility has been well below that of emerging market equities. Over the last 15 years, the volatility of local currency debt has averaged around 12%, which is well short of the level of over 20% for emerging equities.
This realisation should contribute to an improving debt profile. Equally, the understanding that default risk is typically overestimated, especially in local currency debt, and that the risk/reward trade-off is clearly positive should lift the prospects of greater ownership of local currency debt.
Exhibit 1: Local debt volatility has been overestimated
Note: past performance is not indicative of current or future performance; EM: emerging markets; IG: investment grade. Source: BNP Paribas Asset Management, JP Morgan, MSCI, as of 31/12/2017
Index inclusion is one source of demand…
Apart from a reassessment of these attractions of emerging local currency debt, there is also room for giving these bonds a bigger place in portfolios. Looking back over the past 10 years, allocations to emerging debt in global portfolios, and local currency debt in particular, are below average.
We can see a number of triggers for a pick-up in demand. Chinese bonds are due to become part of most major global emerging market debt indices and inclusion of the world’s third-largest fixed income market should automatically create demand as index-focused investors adjust their portfolios. Foreign ownership of the Chinese onshore bond market is currently at only roughly 4%. India can be expected to follow suit in the next three to five years.
…as is investment from foreign investors lagging that of domestic buyers
Another factor for upside potential is the still reasonable foreign participation in this market. The 2017 rally in local emerging debt was driven mostly by local buyers. The share of foreign ownership has not risen materially in most markets or has even fallen in large markets such as Malaysia. There is room for catch-up there.
It is worth noting that these local investors inject a note of stability into these markets and have become more diversified over time, ranging from pension funds and insurance companies to banks and even asset managers. They are adding these bonds to their portfolios in the knowledge and with the full understanding of the local, often idiosyncratic, drivers of this market. This growing domestic investor base has proven an efficient cushion during recent bouts of volatility.
Regarding foreign involvement, the fact that “real money” – from long-term investors such as insurance companies and pension funds – is increasingly involved rather than short-term speculative money should also mean that these investments are not a fad or part of a bubble, but genuine and return-driven, which should help curb market volatility.
What of the currency component of these bonds?
Historically, US dollar trends and US monetary policy have been sizeable factors for emerging market exchange rates. We believe the regime for emerging currencies is currently favourable. Global growth looks strong, and with it global trade, which bodes well for emerging market exporters generally and for commodity exporters especially. Under these conditions, emerging currencies have room to appreciate, which adds an attraction to local emerging debt. We currently see emerging market currencies as the cheapest segment of the overall emerging market asset class.
For us, growth is the main forward indicator for currencies. The current growth trend for emerging markets is the best since 2010, with GDP growth in emerging economies excluding China expected to accelerate towards 4% in 2018. That is also ahead of the rate in developed economies. All three major regions – Asia, Europe and Latin America – are now contributing to this trend, underscoring the momentum in emerging markets.
Emerging market growth trend: best since 2010
Exhibit 2: GDP growth in EM ex-China (Q/Q, SAAR, 2010 GDP-weighted)
Note: emerging market universe: Brazil, Mexico, Colombia, Chile, Peru, Uruguay, India, South Korea, Indonesia, Thailand, Malaysia, Singapore, Hong Kong, Russia, Turkey, Poland, South Africa, Israel, Czech Republic, Romania, Hungary. Source: Haver Analytics, own calculations, through 3Q 2017.
Looking deeper, we believe strongly in the long-term edge in terms of productivity that emerging economies have over the developed economies. This should allow emerging currencies to strengthen over the US dollar and other developed currencies over the long run. In that respect, in our view, emerging currencies are one of the most obvious, if not the only, value trade left when it comes to emerging market assets. That should underpin demand for local currency debt. As long as growth remains strong, we believe volatility will be contained. Improving growth prospects combined with a still benign inflation outlook bode well for local currency debt.
And what about the other components of local currency debt returns?
As said, the market technicals – for example, ownership of the asset class and coupled with that, the demand prospects – and the fundamentals, such as the outlook for economic growth, all look favourable to us. We believe in upside potential on the currency side. Combining the various factors, we are forecasting a total return for the emerging local debt benchmark of more than 10% in 2018, which is more than double that for hard currency debt. Of course, the latter stands to lose ground as US monetary policy is tightened and US interest rates rise, even if this occurs only gradually.
One asset class, multiple opportunities
While the prospects for local emerging debt as an asset class look encouraging, it remains indispensable to keep in mind that it collates a heterogeneous group of bond issuers including countries in different stages of the economic and monetary policy cycle.
Despite the monetary policy tightening cycle in the US, interest rates are likely to be cut in many emerging markets. Thus, it is important to consider factors such as inflation, inflation expectations, the fiscal outlook and technical factors. Interest rates in countries such as Brazil, Russia, Colombia have room to be cut further and countries such as Malaysia and Indonesia are likely to maintain the currently accommodative monetary conditions for a while. Domestic investors in some emerging countries are more active in these markets than in others.
Doing a deep dive on both the structure of the domestic and foreign investor base undeniably helps investors understand the price action of these local bond markets. Gaining an in-depth understanding of the domestic investor base is definitely one of the key elements needed to be able to outperform in these markets since most of the time, many investors regard them as a black box.
We believe this is also a market that requires a broad perspective and an open mind when it comes to investing. Accordingly, we look beyond the traditional benchmarks and also invest in high-quality opportunities that combine a corporate growth story and a sizable yield premium relative to local government bonds. Our interest also extends to up-and-coming frontier countries offering high-carry opportunities, relatively low market volatility and with a low share of foreign ownership.
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