San Miguel Brewery, the Philippine beer maker, astonished
investors in March when it issued 38.8 billion pesos ($800
million) of debt in its local bond market.
The deal was remarkable not only for being the largest
peso-denominated issue on record; it also showed that local
debt markets were more resistant to the global crisis than many
people had feared. The crisis has put emerging markets
through a rigorous test, which they have passed, says
Agnes Belaisch, emerging markets strategist at Threadneedle,
the investment manager. Local debt is looking
increasingly attractive to investors.
Local currency bonds account for more than two-thirds (69%)
of all debt issuance from developing countries so far this
year, as governments pay down external debt and issue more
cheaply in their local markets. As recently as 2004, the
instruments accounted for less than half (46%) of the total,
according to data providers Dealogic.
Debt to GDP ratios in advanced countries are more than 100%,
according to Threadneedle. In contrast, in emerging economies
the ratio is less than 50%, making local institutions a better
source of finance than foreign lenders.
Since April, local currency bond funds have attracted $1.4
billion in new money from investors, according to Boston-based
fund tracker EPFR Global. Compared to emerging market equity
funds (which attracted $33.8 billion over the same period),
local currency debt remains peripheral for many foreign
investors. But one investor described the instruments as
a new and increasingly significant asset class.
The reasons why
The main arguments for investing in local currency bonds are
two-fold. First, many believe developing market currencies will
strengthen on the basis of improving fundamentals against a
weakening US dollar. Nine years ago only a third of developing
countries were rated investment grade; today more than half of
them enjoy that rating. Second, there is the opportunity for
sky-high spreads, which economists say over-compensate
investors for the risks of investing in relatively stable
economies, amid falling interest rates and inflation.
Investment consultants also view local debt as a way of
reducing risk, if the rest of a portfolio is invested in more
Hungarian spreads touched nearly 1,000 basis points
(bps) earlier this year and are now back below 500bps. This
kind of rally would have provided a huge return for Hungarian
forint bond investors, way beyond anything from developed
markets. There has been even more spectacular performance from
the Turkish and Brazilian markets, says Nigel Rendell,
emerging market strategist at RBC Capital Markets.
Longer-dated maturities, around 10 years, offer good value
to investors, according to Rendell. At September 3, 10-year
Czech local currency government debt was yielding 5.1%, 183bps
more than on equivalent German bonds. Yields for Hungarian
forint debt were even higher, at 8.2%, while Polish zloty paper
was yielding 6.1% and Slovakian koruna 4.8%. Despite such high
spreads, default looks unlikely, particularly in light of the
IMFs new lending programmes, including its flexible
credit line, introduced in March.
Yields on Latin American local bonds were even higher than
in eastern Europe. Brazilian five-year local government bonds
were yielding 12.3% (at September 3), Mexican bonds 7.4% and
Turkish lire paper 11.6%, according to RBC Capital Markets. In
contrast, US bonds were offering just 2.3%, showing the upside
potential on local emerging markets bonds.
Jerome Booth, head of research at Ashmore Investment
Management, believes emerging markets currencies are set to
appreciate by as much as a third against the US dollar and says
he views local debt as an insurance policy against
dollar weakness. Ashmore has around a fifth of its $25 billion
emerging market assets in local bonds. He says: When we
talk about the risk-free rate in US Treasuries, thats an
abuse of the English language. Its not true at all. The
US dollar is one of the riskiest currencies there is. The risk
of a sudden reversal in the US dollar is greater than in a
basket of emerging markets currencies. The issue in the global
economy today is how to manage the dollar down slowly without a
Local currency bonds can represent the best route to gain
exposure to individual countries. RBC Capital Markets
Rendell says: Local currency debt is a purer play on the
country than either equities or external debt. [It] gives you
direct exposure to how individual countries are performing,
more so than external debt. Equities are more dependent on how
the corporate in question is performing than on the country
itself. If you want exposure to a countrys fundamentals
the local currency debt market is the best way to do
that. Outstanding volumes of Brady bonds are declining
and Eurobonds can be in short supply, adds Rendell.
Leading UK pension fund consultancy Watson Wyatt is
recommending that clients interested in emerging market debt
invest in local currency bonds. If clients want to invest
in emerging market debt, local currency is an appealing route
to pursue. These markets are deeper and more liquid than the
external debt markets, says Mark Horne, the firms
senior investment consultant.
Emerging market governments rely most heavily on their home
markets for funding; sovereign local bonds account for around
57% of outstanding emerging market debt [see table, p. 29]. The
figure for hard currency government debt is just 6%.
However, the leading index for tracking debt issued by
emerging markets in local currencies (the JP Morgan GBI-EM) has
not done as well as its hard currency equivalent in recent
months. The local currency JP Morgan GBI-EM managed only a
14.3% increase to September 4 year to date, compared to a 22.3%
rise in the hard currency EMBI index.
Some local currency bond funds have lagged the broader
universe of emerging market debt funds so far this year. The
overall US open-ended emerging market bond fund universe
tracked by fund analysts Morningstar was up 23% year to date at
September 2. However, the Pimco Developing Local Markets Fund,
set up in 2005 to target local currency bonds, returned 15% and
the Pimco Emerging Local Bond Fund 19%.
The Dreyfus Emerging Markets Debt Local Currency Fund,
launched in September last year, also trails the broader
universe. The fund was up 13.3% to September 2, compared to the
The £28.6 million Threadneedle Emerging Market Local
Fund, launched in January 2008 to invest in domestic debt, lost
3% of its value in the first half of this year. In contrast,
the Threadneedle Emerging Market Bond Fund, with more than 90%
of its £419 million assets invested in hard currency
instruments, and run by the same manager, was up 3% over the
same six months.
Hard currency emerging market debt funds do seem to
have done a little bit better [than local currency versions]
and its possible there is still a certain amount of risk
aversion to [stand-alone local currency], says
Morningstar senior mutual fund analyst Lawrence Jones.
Investors are willing to go into emerging market debt,
but theres still unwillingness to take currency risk in
those instruments given uncertainty over US dollar direction,
at least in the short to medium term.
Jason Hepner, investment director for global strategy at
Standard Life Investments, is among those sceptical about the
appeal of local currency bonds. Our view is that a lot of
the good news is already in the price for emerging market
assets, at least in the short term, he says.
The Brazilian real has risen 24% against the US dollar so
far this year (to September 3), Hepner points out. A 15% rise
in the Chilean peso and 23% hike in South African rand also
suggest less potential for currency appreciation, one of the
biggest arguments for investing in local currency bonds. Hepner
says: Because emerging market risk appears to have run a
long way and done so well year to date, I would be cautious
about adding at this stage. The price may well have run ahead
Local currency bonds with short maturities (between two and
five years) no longer present as many opportunities as they did
earlier this year, when rates were tumbling, cautions RBC
Capital Markets Rendell. In most countries local
rates are down as far as they will go, with a few exceptions.
Latin America, for example, has done most of the work on
rates, he says.
Trading of local currency bonds is shrinking. Turnover in
the instruments fell back by more than a quarter in the second
three months of this year to $600 billion, compared with a year
previously (data from EMTA, the association for emerging
markets traders). Turnover was also down (by 8%) on the first
quarter. In contrast, Eurobond trading rose 48% in the second
quarter to $374 billion, from the first three months of the
year, suggesting an investor preference for hard currency
Local bonds are falling as a percentage of total emerging
market debt traded; in the second three months of this year
they accounted for 61% of total turnover, according to EMTA,
down from their 72% share in the first quarter and also from
the 68% they held for the five previous quarters.
Evidence suggests that, for a while at least, investors
remain cautious on domestic paper. However, as the San Miguel
deal shows, there are still opportunities. Many investors may
yet be prepared to toast the prospects for local bond
HOW TO INVEST IN LOCAL DEBT
Watson Wyatt, the leading investment consultancy, is
advising its clients, who include leading UK pension funds,
to allocate between 2% and 3% of their portfolios to emerging
market debt. Not a significant amount, but
meaningful, says Mark Horne, senior investment
consultant at the firm. Watson Wyatt suggests around half the
investment goes into local currency bonds. Pre-crisis
we were suggesting that the entire allocation be local; now
we are advising a 50/50 blend [of hard and local currency
There is an increasing choice of investment routes. Fund
flow tracker EPFR Global monitors 84 dedicated emerging
markets local currency bond funds, with $16.9 billion in
assets. The firm follows a further 44 funds with $11.3
billion in assets that are a blend of hard and local currency
instruments. It also tracks 131 hard currency bond funds with
$39.7 billion in assets.
In June 2006 Pictet launched the $447 million PF (Lux)
Emerging Local Currency Debt Fund. More and more we see
[local currency debt] starting to figure as a separate
line, says Simon Lue-Fong, the funds manager.
The base scenario for us is that [local currency] will
become more mainstream, especially among institutional
investors looking for coupon-paying instruments that can be
used for liability matching and that are uncorrelated to
other assets they hold. Threadneedle, Dreyfus and Pimco
are also among those firms to have launched local currency
debt funds in recent years.
Watson Wyatts Horne advises investors to opt for
funds that invest in both local and hard currency: We
think a blended approach is prudent and seek out skilled
managers who can invest across external and local currency
Lawrence Jones, mutual fund analyst at Morningstar, says:
You will find a lot of the emerging markets hard
currency funds will have a stake in local currency bonds,
typically between 7% and 20%, depending on how the manager is
feeling about the dollar valuation to these currencies.