Puerto Rico's bond yields shot up after President Donald Trump's pledge to "wipe out" its debt following the devastation caused by Hurricane Maria. High levels of household debt in the developed world and the beginning of normalization of interest rates by major central banks make emerging market debt an interesting alternative for investors.
This asset class has developed tremendously over the past two decades. Before the turn of the century, all that investors could hope for were perhaps a few dollar-denominated sovereign bonds from major developing countries. Nowadays, an array of options exist: There are corporate as well as sovereign bonds, denominated either in local currencies or in major ones such as dollars or euros.
The World Bank had a hand in this. Almost a decade ago, it launched its Global Emerging Markets Local Currency Program (Gemloc) initiative to help emerging markets develop their local currency bond markets. Doing so offers local governments and businesses a way to get funds without taking on foreign currency risk and gives foreign investors a way to diversify their exposures to these countries.
While many foreign investors still prefer to invest in dollar- or euro-denominated bonds when it comes to sovereign or corporate debt issued by entities in developing countries, local currency debt has some advantages.
For one, arguably it would be more difficult for a country to default on debt issued in its own currency. This would hurt domestic businesses and individuals first, as they have the biggest exposure. Politically, this would not sit well.
Another thing to bear in mind for investors who can stomach risk is that domestic currency bonds offer more varied exposure. Smaller, niche companies that could give higher returns (with higher risk, of course) are more likely to issue debt in local currency, as it is easier for them.
Perhaps the most important reason for a foreign investor to put money in local currency bonds is the "carry" factor; as the local currency appreciates, the total return of the bond for the foreign investor increases. Of course, the reverse is also true. In case of sharp devaluation, the foreign investor stands to lose more than the local one.
Most of the double-digit return of local-currency emerging markets bonds year to date comes from currency effects, noted Jason Daw, head of emerging markets strategy at Societe Generale. He looked at the iBoxx Global Emerging Market Index (GEMX), which has returned 12% this year, and saw that the hedged return was just 3.5%. In other words, 70% of its performance was due to currency appreciation.
This has further to go. Developing countries' currencies are likely to be supported by higher economic growth, healthier external balances and capital inflows. Daw expects the majority of returns in local currency bonds to come from currency appreciation before the end of the year, just like it did all year.
China is prominent on his overweight list. Yields on 10-year bonds have been stable in a range of 3.5% to 3.7% since April, but "there is greater potential for yields to head lower from here if growth expectations start to shift lower," he wrote in a quarterly update on the bond market. Bond yields move inversely to prices.
The renminbi, which has corrected weaker in the past month, is "well supported" by a "significant improvement" in the balance of payments as well as dollar weakness, in Daw's opinion.
Other overweight local currency bond positions Daw recommends are Turkey and South Africa due to their high yields and because the Turkish lira and South African rand are expected to perform well to the end of the year.
Daw is also overweight Mexico, where he believes that most of the upward move in yields "is in the rear view mirror," and Hungary, where the central bank targets lower long-end yields.
As the Federal Reserve normalizes monetary policy ever so slowly, emerging markets seem to have evolved enough so as to withstand a gradual increase in dollar interest rates. For foreign investors, this makes them a good place to diversity.