Why hasn’t the rebound in local currency bonds been more robust?

Talk of Federal Reserve tapering last year contributed to violent outflows from funds dedicated to emerging market (EM) debt, evaporating liquidity, and a selloff in EM currencies vs the dollar. What a difference a year makes: even though expectations for the Fed to raise its benchmark interest rate from zero have shifted to earlier in 2015 than previously expected, EM bonds have fared well so far in 2014. Stalwart investors waited for the smoke to clear (apparently ignoring the geopolitical risk from Ukraine) and rode the rebound in hard currency EM bonds in the first half of 2014.

The JPMorgan EMBI Global index of dollar-denominated EM debt posted total returns of 9.1 percent in the first six months of this year, leaving in the dust the S&P 500 and US junk bonds, which were up 6.1 percent and 5.8 percent, respectively. JPMorgan’s own strategists were gobsmacked – at the start of the year, they had forecast a 4-5 percent rise in the EMBI Global. 

What about EM bonds denominated in local currencies, though? The GBI-EM index of local debt returned 5.9 percent in the first half. Not bad, but perhaps not enough to compensate opportunistic investors for the currency volatility. Meanwhile, local bond funds have continued to bleed capital. In the year to August 6th, EM local bond funds have had a net US$6.4bn in outflows, in sharp contrast to the US$20bn of inflows that they saw at this time in the first seven months of 2013, according to fund tracker EPFR Global. EM hard currency bond funds in the year to August 6th enjoyed a net US$13.8bn of inflows.

Herein lies the rub: outperformance of EM dollar bonds has a lot to do with how well US Treasuries have done this year, not necessarily a change in the fundamental outlook on EM economies. Banks use Treasuries to benchmark EM dollar bond prices and performance.  

Local currency bonds will continue to be dogged by two factors. First, the EM growth premium has shrunk. Previously a growth premium existed in emerging markets, compared to developed ones, which convinced investors and companies the additional volatility and challenges of doing business were worth it. That has changed. Indeed, the difference of real GDP growth in non-OECD economies over OECD economies in 2014 and 2015 is forecast by EIU analysts to be the smallest since 2002.

Second, using the parlance of the asset management industry, emerging markets have become more of an alpha trade rather than a beta trade. That means returns will more likely come from the skill of an asset manager to identify value or pricing imbalances in a particular bond issue, especially in a relatively illiquid asset class like local debt, instead of broad exposure to the market itself.

That is not to say that local bonds are without value. The diversification benefits for institutional investors are still attractive. The asset class is evolving beyond run-of-the-mill rupiah or peso bonds. For example, the offshore yuan bond market has been booming and had record issuance worth $21 billion in the first quarter of 2014. Appetite for the paper has been strong despite a bout of weakness in the yuan. In addition, sovereign borrowers such as Tunisia and Pakistan are planning for the first time to issue Islamic bonds – known as sukuk – in local currency following the UK’s maiden sukuk issue in June. 

What’s clear is that local debt investing is becoming more complex. It’s not enough anymore to buy the ETF and reap the rewards. Global investors will have to dedicate resources and acquire relevant expertise to truly be local when it comes to their fixed income portfolios.  

The evolution of local bond markets as an asset class is actually the subject of an EIU webinar to be held on September 3rd in Kuala Lumpur. Find out more here.