Local currency spin gives emerging market debt an edge

Emerging market debt is one of the fastest-growing asset classes in the global investment universe. It is growing so rapidly that the Investment Management Association (IMA) created a separate sector for global emerging market bond funds in January this year.

One driver of this growth is the increasing issuance of high-yielding local currency bonds. They have found favour among developed market investors, who since 2008 have been forced to look beyond traditional fixed-income asset classes for yield.

However, the sharp depreciation recently seen in some developing market currencies has underlined the risks inherent in investing in this asset class, leading some to question whether moving out of traditional US dollar-denominated emerging market debt is worth the risk. The origin of EMD is in so-called hard currencies: large, liquid, developed market currencies such as the US dollar, sterling and the euro - the US dollar is the dominant form.

Find out more about Standard Life's Emerging Market Debt fund by reading: Fund profile: Standard Life Emerging Market Debt.

Refinancing help

John Stopford, head of multi-asset at Investec Asset Management, explains that the market began to develop around 30 years ago, when developing countries looked to western investors for refinancing help.

"In the 1970s and 1980s a number of emerging markets got into problems and had to reschedule debt. It started out as loans, but then morphed into the hard currency bond market," he says.

Since then, the US dollar-denominated emerging market bond sector has grown to more than $600 billion (£357 billion) as developing markets have harnessed foreign investment to grow their economies.

However, Nicholas Jaquier, emerging market economist at Standard Life, says borrowing in hard currency is not ideal for many developing economies. He warns: "If you issue a bond in hard currency, you face the risk that if and when your currency depreciates, your debt will increase in value and you will find you can't repay it. This was the case for some countries during the Asian financial crisis of the 1990s."

Thus, as emerging economies have grown and domestic pension funds and insurers (natural buyers of sovereign debt) surfaced within them, governments of developing countries have issued greater amounts of local currency debt.

Following the launch of the dominant benchmark in the sector, the JPMorgan Government Bond Index, Emerging Markets (GBI EM) in 2005, the local currency bond market has grown to $940 billion - $440 billion larger than its hard currency equivalent.

Credit quality

The emerging market local currency debt market has better credit quality than its hard currency sibling: the average local currency bond is rated investment grade BBB+, compared with BBB for the latter. The manager of the BNY Mellon EMD Local Currency fund, Urban Larson, says this higher rating reflects the fact that, to issue debt in its own currency, an emerging economy needs to have "a very sound financial system".

Stopford says a country issuing bonds in its own currency avoids the harmful currency movements that caused many Asian countries to default on US dollar debt in the 1990s and is more likely to get its money back. Perhaps the most attractive thing about local currency emerging market bonds is the yield. Local currency debt currently yields 6.6%, compared with 5% from hard currency debt.

However, this high yield reflects the fact that despite being of better credit quality than hard currency bonds, local currency bonds are far more volatile. Jon Brager, senior credit analyst at Hermes, says: "Yields on local currency bonds are highly sensitive to factors such as inflation, central bank policy, and current account deficits and surpluses. But your biggest risk is currency: if the local currency depreciates the way we just saw in Indonesia and Brazil, you face capital loss."

Moreover, although the local currency market is larger in terms of total value, the number of countries issuing debt in their own currency is smaller. Jaquier says:

"The local currency market is more concentrated: you have 16 countries in the index and 20 countries where you can access the local market, while more than 60 countries have dollar-denominated debt outstanding - so hard currency is much more diversified. You have more elements to play with."

Of course, for those investing in emerging market debt through a fund, many of the risks associated with local currency can be reduced through diversification. However, hard currency bonds are undeniably less volatile and, as Brager observes, in periods of emerging currency weakness will benefit from the relative appreciation of the US dollar or sterling.

Emerging market debt funds

Few funds investing in local currency bonds have escaped the past six to 12 months unscathed. Most currently reside in the bottom quartile of the global emerging market bond sector over one year. Of the 10 funds listed in the IMA global emerging bond sector, only two - First State Emerging Markets Bond and Aberdeen Emerging Market Bond - have achieved positive returns over the past 12 months to mid June.

However, according to the manager of the Schroder ISF Emerging Market Local Currency Bond fund, James Barineau, the recent tough environment for local currency bonds means the only way is up. "A number of emerging economies have adjusted to reduced global liquidity by raising interest rates. Now the market has settled down and currencies stabilised, those rates make local currency an attractive part of the EMD opportunity," he says.

Barineau takes an unconstrained approach, which means that - unlike many of his peers, who only invest in sovereign local currency debt - he is free to invest in corporates. That said, eight of his top 10 holdings are sovereign bonds - the highest allocation is to Brazil, at 13% of the fund, and the lowest is to Indonesia, at 3.61%.

Outside of the global emerging market bond sector, several funds have exposure to EMD but carry much less currency risk than a hard- or local currency-dedicated EMD fund.

One example isMoney Observer fund award winnerLegg Mason Brandywine Global Fixed Income, which has more than 20% of its fund allocated to emerging economies and hedges its currency exposure. The fund has sat in the top quartile of global bond performers since its launch in 2008, returning 46% over five years.