In this piece, we examine a few issues with regard to the local currency emerging market bond asset class for portfolio managers. Investment committees and advisors who are currently in this space or who are contemplating a potential placement should consider these factors.
This asset class has been in a structural upturn over the last few years due in part, to improving balance sheets and relatively high real yields. The middle class of these countries has strengthened although it is a struggle for many as the gap between rich and poor persists.
Initially the Emerging Market Countries, (EMC) story consisted of the "BRIC" countries that include Brazil, Russia, India and China, however, it is now expanding to include South Korea, Indonesia and Turkey among others. Many of these countries have a different set of yield curves and varied monetary and fiscal policy.
Most of these countries has the ability to issue bonds in their own currency to better reflect the economic reality in their own country. This local currency bond market created a new opportunity set for investors. Credit upgrades, currency appreciation and high real yields offered a "risk to reward" that was too appealing to pass up for investors. All of these factors are not as strong as in the past; although, a selective investment to Emerging Market Debt (EMD) can continue to be an additive component to a portfolio.
- Expanding opportunity set as more countries develop their debt markets and corporations obtain funding through their own currencies.
- Participation in the Emerging Market Growth (EMG) potential with potentially less volatility than equities.
- Under allocation in many institutions asset allocations may allow for an allocation lift in valuations.
- The Emerging Market world continues to suffer from political unrest and in some cases a slow evolution to democracy.
- Hot money trade
- Some Emerging markets are extremely dependent on commodity markets.
- Less true real yield opportunities
Local currency bonds such as Brazilian Debt issued in the "Real" is seen as a way to diversify away from the dollar and garner a better yield. The sources of return and risk should be dissected.
A. Currency appreciation:
This is one portion that is taken as a given by much of the investment community. The belief is that the dollar is headed down and so the simplistic assumption is that Emerging Market Currencies will hedge the portfolio. The problem with that is EMC; while generally growing faster than the United States, all have currency issues to deal with especially those with fragile export sectors. This portion of the return expectation should be tempered and managed carefully.
This is difficult to assess as each yield curve in the world has various segments that are more attractive than others. We do not believe that a broad based "Beta Bet" will work in today's environment since the opportunity set needs careful examination from a seasoned manager.
This has been a positive driver of returns over the last few years as many EMC's have been upgraded. Potential for upgrades remain, however in a slowing global economy, this "asset class" return potential should also be tempered. Given the complexities of sovereign debt credit analysis, we recommend a placement with an astute manager.
D. Risk-on trade:
This "asset class" does not perform well in a risk averse environment; therefore, it's diversification benefits may be muted at a time that a portfolio needs a non-correlated asset class.
It is important to understand the rationale behind a placement in this asset class is just as important, whether the strategy is actively or passively managed. One needs to determine if the placement is a tactical or strategic move.
It is difficult to make a strong case for a strategic placement that is passively managed as the currency and debt markets are too dynamic to leave to a passive strategy.
While Emerging Market bond and currency exposure also makes sense to a degree, the specific risk is very high. A comprehensive global bond portfolio with active currency management adds significantly more potential alpha and portfolio Sharpe enhancing qualities.
I-Shares-Emerging Markets Local Currency Bond Fund
- Sec 30 Day Yield 5.23%
- Duration 4.11
- Rated BBB
- South Korea 21.74%
- Brazil 12.11%
- Mexico 7.15%
Market Vectors Emerging Market Local Currency Bond ETF
- SEC 30 Day yield 5.56%
- Duration 4.89
- Poland 9.97%
- Malaysia 9.52%
- Turkey 9.49%
- South Africa 9.11%
- Brazil 8.98 % 5.15%
Wisdom Tree Emerging Markets Local Debt Fund
- SEC 30 Day yield 4.57%
- Duration 4.48
- Malaysia 10.39%
- Mexico 10.28%
- Indonesia 10.28%
- Brazil 9.99% 5.15%
Since these ETFs are paid in U.S. dollars, the yield minus the current US CPI is an appropriate gauge of the real yield. Since the US CPI is approximately 2.7%, the real yield carry is over 2% for all of these ETFs.
That carry is not free; however, the differential can be wiped out very easily by currency movements. Unless your firm has a clear conviction on the forward looking basket of currencies versus the U.S. dollar in any of these instruments, Zenith recommends that these funds be avoided.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.