Morningstar reported that Emerging-Market (EM) bond funds gained around 18% in 2012 - best performer under the fixed-income category. According to them, investors bought $20 Billion from Jan - Nov 2012, almost double of the 12 month total in 2011 that came in at $12.5 Billion.
One thing is for certain - EM bonds are popular, but what is the impact on its underlying currencies?
The relationship is simply to understand: Holders of USD need to convert to SGD in order to purchase SGD denominated bonds. This will have a deflationary pressure on the USD, and strengthens SGD as demand for SGD increase. The same logic is applied to INR, THB, HKD and all the other EM currencies whose bonds are popular.
Bonds are not the only assets foreign investors are interested in. Purchases of properties and stocks to a lesser extent from foreign buyers provide the same deflationary pressure on the USD and strengthens the underlying EM currency. However is this trend going to continue in 2013?
There are signs that a potential reversal is coming back, with falling yields in Italian and Spanish treasuries demonstrating higher demand for Eurozone bonds. On the other side of the Atlantic, yields are climbing back up within US shores due to confidence in the US market and the overall global economy (see chart below). As for EM bonds, yields have dropped from an average of 9% in 2008, to current 4.4%. All these eat into the rates differentials that make EM bonds attractive enough to overlook many of the problems that comes with it.
Should this trend continues, the incentive to hold EM bonds may dissipate altogether as the minute yield differentials may not be enough to compensate for political and credit risks. Even when these risks are manageable, liquidity risk remain sticky for EM bonds such as Singapore as buyers/sellers are not readily available (hence the label EM rather than Developed Market).
Nonetheless, concerns above does not necessarily mean that current demand will vaporize immediately. But certainly the golden years of EM bonds may be over and we're looking at a sunset window of opportunity here. As for the underlying currencies, demand in 2013 may still remain strong, but do not be surprised in a USD comeback in the later half of this decade.