Investing in local-currency emerging market bonds won't necessarily bring a quick or easy profit, but may be worth it for long-term, patient investors, argue Gerardo Rodrigeuz, managing director of BlackRock's emerging market team and Sergio Trigo Paz, head of emerging market debt at BlackRock.
During the darkest days of the 2008 and 2009 financial crisis, emerging market (EM) fixed income showed surprising resilience. Investors seeking yield and diversification in the developing world helped to propel the EM local debt market to its current size of just over $1.5 trillion, significantly larger than the more familiar hard-currency EM debt market.
However, EM local debt has hit a crossroads. The waning of monetary stimulus in the US has triggered a sharp price correction and the bellwether local debt index, JP Morgan’s GBI EM, has fallen more than 6 per cent since May 2013.
Notwithstanding that, we see encouraging and important signs for investors seeking to benefit from the EM growth story.
The rise of local fixed income markets has given asset allocators a new set of tools, enhancing their ability to construct portfolios with better risk-adjusted returns. Although correlations tend to be high between EM equities and fixed income, investors are finding new diversification opportunities across asset classes and in local markets.
Market drivers in different countries tend to be more local and idiosyncratic than ever before, from politics in Turkey, to the effects of China’s growth on commodity exporters like South Africa. Countries are also increasingly being judged by the policy decisions that they make rather than factors outside their control. As policymakers in some countries develop more credibility in setting monetary policy, there will be greater divergence with other risky assets as well as country by country. If growth is expected to accelerate in Mexico but flatline in Russia, for example, investors have more opportunities to differentiate between the two, both because of the varying interest rates and greater liquidity in currency markets.
With deepening differences among countries and changing dynamics in asset prices, opportunities are likely to appear. That said, finding relative value requires both an understanding of the fundamentals and insight into local policy and currency markets.
For EM countries, outcomes will depend largely on the capacity of authorities to adjust and adapt domestic policy tools. Those countries that rise to the challenge with sound policy choices stand to be rewarded.
Investors should look for places in which confidence in policy-making is being restored, such as those outlined below:
- The prospect of a new reformist administration and the possibility of inclusion in global fixed income indices make the high-yielding local debt of India an attractive proposition.
- Recent volatility in the currency and cyclical weakness of the Brazilian economy are providing a great entry point for investors that have the appropriate medium-term horizon. With five-year bonds offering 6 per cent real rates and 12 per cent nominal rates, combined with a central bank that has a credible inflation targeting regime and relatively low debt ratios, we think Brazil local bonds should be a core holding for fixed-income investors.
- Nigerian bonds have also become an attractive investment alternative. Now the biggest economy in Africa, Nigeria benefits from high growth, a current account surplus, ample reserves of foreign currency and low debt levels. Nigerian five-year bonds offer 13.5 per cent yield in a context of good market liquidity, a solid and well regulated financial sector and inflation under control around 8 per cent.
We also believe the development of local currency fixed income markets is providing emerging economies with a more solid macroeconomic backdrop. As local foundations continue to strengthen, we look for local business cycles – rather than international flows of capital – to become the most important determinants of local financial asset prices.
This won’t happen overnight, and the transition will be neither uniform nor smooth. But over time, the more local rates come to reflect local economic conditions, the more attractive these markets will become to patient global investors seeking growth and diversification.
List of local-currency emerging market bond funds
Aberdeen Global – Emerging Markets Local Currency Bond
Baring – Emerging Markets Debt Local Currency
BlackRock Global Funds – Emerging Markets Local Currency Bond
BNY Mellon – Emerging Market Debt Local Currency
First State – Emerging Markets Local Currency Bond
HSBC – GIF Global Emerging Markets Local Debt
Invesco – Emerging Local Currencies Debt
Investec – Emerging Markets Local Currency Debt
MFS Meridian – Emerging Markets Debt Local Currency
Pictet – Asian Local Currency Debt
Pictet – Emerging Local Currency Debt
Pictet – Latin American Local Currency Debt
Schroder – ISF Emerging Market Local Currency Bond
Threadneedle – Emerging Market Local