Emerging Markets Attract Foreign Investment Via Local-Currency Bond Funds

Includes: LEMB
by: Matt Tucker, CFA

A decade ago, buying a local-currency emerging-market bond fund would have been nearly impossible. In the “old days," emerging-market governments primarily issued bonds that were denominated in foreign currencies, like US dollars, Japanese yen or euros, when they wanted to raise capital.

Issuers like Brazil, Poland and Indonesia used to target this external debt at foreign investors. Their local currency debt was targeted at local investors, like pension plans, insurance companies and private individuals within the country. Many of these countries directly restricted foreign investors from buying local currency bonds through capital controls, punitive taxes or regulations. A US investor looking to access a Brazilian bond denominated in reals would have been facing an uphill battle.

Some issuers, like China and India, still restrict foreign investors from purchasing their local-currency debt. Others have taxes on foreign investors, which are designed to limit the amount of foreign capital, like Brazil’s 6% IOF (Imposto sobre Operações Financeiras) tax.

But times are changing, and many EM issuers are relaxing such restrictions. Some countries are now issuing bonds that are denominated in local currencies but targeted at international investors. These “global” bonds trade in global clearing and settlement systems, like Euroclear or the Depository Trust Company, instead of local clearing systems. The Philippines, Russia, Colombia, Chile, Brazil and Egypt have all issued global local-currency bonds.

Last week, my colleague Russ blogged about using emerging-market debt as a long-term option for investors worried about a deterioration of credit quality in the developed world.

Local currency emerging market bond ETFs can offer investors exposure to emerging markets without the same type of potential volatility that is typically associated with equities. Adding an allocation to local currency EM debt can also help an investor diversify out of the US dollar or away from developed market currencies, like the euro or the yen.

Additionally, because yield levels are higher than for developed market bonds, local-currency EM debt can increase the yield of a fixed-income portfolio.

Emerging-market debt is a relatively new asset class for many investors, especially bonds that are denominated in local currencies, but it offers another tool with which to manage fixed-income exposure.

Potential iShares solution: LEMB.

Disclaimer: Diversification may not protect against market risk.

Bonds and bond funds will decrease in value as interest rates rise. In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.

Narrowly focused investments typically exhibit higher volatility and are subject to greater geographic or asset class risk. Bond funds may be subject to credit risk, which refers to the possibility that the debt issuers will not be able to make principal and interest payments.

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