by Dewi John.
Emerging market debt funds come in many flavours, with one of the principal distinctions being between hard currency (HC) and local currency (LC) offerings.
HC bonds are dollar-denominated. This article focuses on funds investing in emerging market debt denominated in the currencies of their issuers. While HC bonds offer a mix of government and corporate issuance, with a broad range of sector exposures with the latter, LC is almost entirely government debt. What’s more, there’s less to chose from at the country level, with the main LC index comprising 20 countries (and about 80% of issuance from half of these) as opposed to about 75 in the HC universe.
From the start of 2008 to the end of 2021, the Lipper Global Bond Emerging Market Global Hard Currency classification returned 55.6%, with its local currency equivalent lagged considerably, delivering just 18.3%. However, local currency funds have not been hit as hard as their hard currency peers year to date, with the former falling about 18% to mid-July as opposed to 24% for the latter. But no-one is going to jump for joy at either an 18% or 24% loss.
So why bother?
Many emerging market central banks responded quickly to resurgent inflation are therefore further ahead of developed market central banks in the interest rate cycle. That tends to be good for LC denominated bond yields. Local currency bond funds are currently offering a yield broadly in line with global high-yield funds (about 6%), greater than hard currency GEM funds and more than three times that of global corporate bonds.
With the US Federal Reserve still tightening, the dollar is likely to strengthen in relation to other currencies, so increasing debt service costs for EM countries and corporates issuing debt in dollars, as a result increasing default risk. That’s not been an issue while rates were stable and low, but has led to an exodus from these assets over the course of the year. HC EMD will likely be worth a revisit when the Fed has reached the apex of its tightening cycle and yields have blown out, but we are not there yet.
While funds in the hard currency IA sector have seen outflows of £588m over the second quarter, local currency funds have attracted cash—albeit to a modest degree.
An important component for LC return, alongside coupon income, is the exchange rate effect: if the currencies in which the debt is issued strengthen relative to the pound, then this will increase the returns for sterling-based investors, and vice versa. We are going into a likely a recession that could be negative for the asset class, but FX analysis is a dark art with many moving and interacting parts. Nevertheless, this is certainly a risk of which to be cognisant.
It’s a sign of the times that the two top funds over three years—SPDR Bloomberg EM Inflation Linked Local Bond UCITS ETF and Colchester Local Markets Real Return Bond I USD—are inflation-linked. So, if inflation continues unabated this could still be a good approach, though a drop into global recession could choke off the inflationary tiger.
Table 1: Top-Performing Global Emerging Bond—Local Currency Funds Over Three Years (with a minimum five-year history)
All data as of June 30, 2022; Calculations in GBP
Source: Refinitiv Lipper
This article was originally published in July Moneyfacts, p15
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