Why Now for EM Local Currency Debt?

Transcript

We think it’s an interesting time at the moment to be thinking about diversifying into EMLC debt, particularly vs developed market (DM) debt. Obviously over the last few years yields in DM have fallen precipitously: round about 25% of international debt is negative yielding, and at the same time due to these falls in yields, quantitative easing by central banks particularly in the DM world, you’ve seen durations rise, so effectively DM bond investors are waiting longer to get less.  

So how does this yield and duration balance look? On this chart it illustrates the differential that you can see, between the yield and duration of developed market debt -- relatively high duration and very low yields --  versus emerging market local currency debt, which retains relatively high yields at a relatively lower duration, implying that the price risk involved in higher yields is noticeably less when it comes to local currency debt than you see in developed markets. As I said earlier, DM investors are waiting longer, i.e. they have longer duration portfolios, to get less - much lower yields.

I think this is where EM local provides diversification benefits for investors particularly when you look at it from a European perspective. So let’s look at the European perspective in a little bit more detail.

The next charts show the historical yields of the EM local index versus selected markets in Europe -- in this case 5-year bunds, so a similar duration asset to the EM local benchmark and UK gilts. And you can see this long term downtrend we have seen in developed market rates in dark blue versus EMLC debt and you see the differential in grey that's been quite consistent, that differential, in terms of yields around about 500 basis points currently. On the left hand side looking at EM versus bunds around 430 basis points versus gilts. This we think is attractive as a relative value perspective for investors in this region.

So how do things look from a valuation perspective? We’ve been in an environment, in terms of markets, where valuations have got relatively stretched and very extended in many asset classes. This is not the case when it comes to EM local currency. The currencies of EM have weakened over the last few years quite notably to the point where now they look extremely cheap versus long-term history. This is even the case not only versus the dollar, but also vs. European currencies and versus sterling. Euro and sterling appreciation last year means that EM local currencies denominated in the euro or in sterling are at all time lows, so ironically in a world where valuations are stretched, when it comes to EMLC this is a relatively cheap asset class from a valuation perspective and as a result looks quite attractive. 

So let’s put the current situation in historical context. This chart shows the 12-month rolling returns of the asset class denominated in euro and sterling terms. Now you can see here, in the light and blue bars the relatively positive skew you’ve seen in terms of returns of the asset class over time (this is the rolling one-year returns) over the long term.  That relatively strong coupon return, some capital appreciation from falling yields and the movement of currencies broadly versus the euro and sterling, have meant that returns have been pretty positive for investors based in Europe and the UK.  However, in the last couple of quarters what we’ve seen is that the dollar has weakened most notably against developed market currencies rather than EM currencies. As a result, the returns of the benchmark in euro and sterling have lagged – they’ve actually been negative up to the back end of last year on a 12-month basis. So, as a result, from an entry point of view we think the asset class looks interesting.

Another consideration to make when investing in EMLC debt is the diversification it brings – not only to the portfolio (diversifying out of DM bonds) but also diversification in terms of economic cycle, interest rate cycle, inflationary cycle, and even political cycle. We think this adds to portfolios overall in terms of diversifying the outcomes for investors.