Emerging market local currency debt: A mainstream asset class.

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1 Emerging market local currency debt: A mainstream asset class. As emerging market (EM) debt evolves as an asset class, it grows as a strategic holding for an expanding pool of investors, especially those searching for yield and diversification. A key part of the recent development and reappraisal of EM debt is the increasing significance of local currency bonds as part of the universe. The global financial crisis of 2007/08, and the resulting deterioration in public finances across the developed world, led to a favourable reappraisal of sovereign risk in EMs, with local currency sovereign bonds emerging as a complement to US dollar-denominated sovereign debt and an attractive alternative to developed market local currency sovereigns. Emerging market local currency debt at a glance EM local currency debt has developed into a deep and broad asset class. It offers multiple sources of risk and return, similar to traditional fixed income, and investment decisions are not just credit-based. As the market develops, opportunities for diversification and exposure to more stable economies increase. While there are a number of challenges for investors, various instruments and levers can be used to help mitigate and diversify risks. EM local currency debt can be accessed in a variety of ways. Flexibility can allow managers to navigate the rich opportunity set. The development of emerging market local currency debt The recognition of some emerging economies low indebtedness, large foreign currency reserves, often robust anti-inflation policies and commitment to structural reforms have helped EMs mitigate some of their perceived added risk. Alongside this, as local financial institutions (banks, pension funds, and Exhibit 1: Development of the EM debt markets EM US dollar denominated debt Index market capitalisation ($bn) insurance companies) have developed, they have become natural buyers of these local currency securities. As a result of the development of EM debt, an EM local currency debt market has emerged, primarily made up of bonds issued by governments of emerging market countries and denominated in the currency of the issuer. EM local currency debt Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 Dec 13 Dec 14 The EM dollar index shown is the JPMorgan EMBI Global index and the EM local index shown is the GBI-EM Global Diversified index. Source: JPMorgan thecapitalgroup.com.au Capital International, Inc. thecapitalgroup.com/asia Capital Group Investment Management Ltd ABN

2 Based on index market capitalisations, the EM local currency debt market is now significantly larger than the EM US dollar-denominated market, at $941 billion¹ compared with $651 billion² as at the end of 2014 (see exhibit 1). This local currency debt index refers to the more accessible markets for investors and so excludes those restricted issuers, such as China and India. However, according to the Bank of International Settlements, the actual US dollar equivalent size of the local debt universe, which includes issuance from countries for which data is available, is in excess of $11 trillion. When EM debt was purely US dollarbased, investment decisions were primarily credit driven. Now, with the emergence of an EM local currency debt market, investors need to take an approach much closer to that of traditional fixed income in order to accommodate multiple drivers of risk and return. The key drivers of returns in the EM local currency debt market include movements in currencies and domestic interest rates and, increasingly, in the shape of the yield curve. The shape of a particular market s yield curve is primarily driven by expectations for short-term rates and a risk premium, which in part can reflect credit concerns and the degree of uncertainty about the future path of rates and inflation: concerns over rising inflation can lead to a steepening curve, whereas hawkish central bank policies could lead to the curve flattening. Demand can also influence the shape of the curve. For example, local buyers may favour a different part of the yield curve compared with offshore buyers. More generally, as local currency bond performance is often closely linked with the macroeconomic conditions and policies of various issuers, investors can expect to see a far greater dispersion of returns across individual sovereign markets. Therefore, country selection is a key driver of returns for an EM local currency debt portfolio. What makes this market an attractive option for investors? As investors focus more on differing local fundamentals rather than uniform external factors, differentiation will be increasingly important. Having repriced meaningfully after tapering comments by the US Federal Reserve (Fed) in May 2013, EM local currency debt is currently an attractive investment option with a significant yield premium. It is a diverse and liquid universe that provides the opportunity to invest in mostly investment-grade countries. A chance to invest in more stable economies The EM local currency debt market provides investors with an opportunity to gain exposure to emerging countries that are more economically advanced and stable, such as Mexico and Poland. The development of local currency issuance is typically part of the process of a country moving up the credit spectrum. This development is due to factors such as the advancement of the domestic financial sector, which provides a natural buyer for local currency debt, and a strong track record in US dollar-denominated debt issuance. As a result, local currency debt issuers have a higher average rating of A compared with a rating of BBB for EM US dollar-denominated sovereign debt with most issuers enjoying investment-grade status. EM countries that issue local currency debt also tend to have strong fundamentals. Many have low or declining debt-to-gdp ratios (see 1. JPMorgan GBI EM Global Diversified index. Source: JPMorgan 2. JPMorgan EMBI Global index. Source: JPMorgan 2

3 exhibit 2), which can provide some reassurance for investors who are cautious of higher volatility in EM GDPs. While developed economies such as the US have started to deleverage and so lower their ratios, the absolute levels are still well above those of emerging economies. Increasing levels of stability can also be seen through the ever more common domestic disinflationary measures in many of the emerging economies, and local currency bonds can be used to capitalise on these improvements. Many nations are now better equipped and more willing to bear down on inflation, be it through monetary policy, Exhibit 2: Government debt as % of GDP (as at end-2013) % Brazil Mexico Poland Turkey South Africa Malaysia Indonesia Colombia US UK Eurozone Source: Bloomberg deregulation or labour market reform, as we have seen in India in the wake of Prime Minister Narendra Modi s election in May As this happens, there is plenty of scope for both real and nominal bond yields to fall and show a degree of convergence with yields in developed bond markets. Providing diversification The inclusion of EM local currency debt can diversify an investor s portfolio in terms of economic and financial cycles, especially compared with many developed markets. Many emerging countries that issue local currency bonds have divergent interest rates cycles that reflect their individual monetary and economic policies. While the Fed kept its policy rate at 0.25% with a view to potentially raising rates in 2015, we saw the Colombian central bank raise rates, citing a healthy economy. Turkey surprisingly hiked rates in January 2014 in an attempt to defend its weakening currency (see exhibit 3). As the market develops, investor opportunities increase An advantage of investing in EM local currency debt is that, as the market continues to expand and deepen, investors can find more nuanced ways to generate returns. Take, for instance, the development of yield curves. Local yield curves of EM sovereigns tend to be quite varied, as emerging countries can be at different stages of economic and financial cycles at any given time. By investing in local currency bonds, investors can evaluate relative value along the yield curve in individual markets as well as value 3

4 Exhibit 3: Diverging policy rates across EMs and major economies Euro US Brazil Colombia Turkey Indonesia Hungary % Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 Dec 14 Mid-month data for the key policy interest rates of the respective countries. Data as at 31 December Source: Bloomberg across various markets. There has been a significant building out of yield curves already in various markets. One of those that has notably extended is the Mexican peso yield curve. Mexico, which currently has an average market weight of around 10% in the index 3, has extended its local yield curve significantly over the last decade or so, while there has been an overall downward movement in yields over the period (see exhibit 4). Investors become more comfortable with taking a longer-term exposure as domestic policies evolve, and as governments seek to extend their yield curves further, the range of investment opportunities will continue to broaden. Of course, supporting investors ability to move along and between the curves is the liquidity of the asset class. As one of the more liquid asset classes to invest in, EM local currency debt enables investors to use country selection to their advantage. The liquidity of the market has withstood some major tests, including the peak of the credit crisis, when bid-offer spreads of local currency bonds remained relatively low compared with US dollar-denominated bonds. This advantage is growing as liquidity continues to improve. Liquidity is expected to gain momentum for reasons such as active debt management of governments, an increase in the number of market intermediaries, and deepening pools of local institutional demand. In a number of cases, governments have been steadily replacing external debt with local currency debt wherever possible to reduce their foreign exchange risk and exposure to sudden shifts in foreign investor sentiment. Value opportunity At the time of writing, in 2015, there appears to be a value opportunity within EM local currency bonds. Slowing growth in many emerging economies, along with weak commodity prices, may provide room for some EM central banks to take further easing measures, which would support the local currency bonds. Furthermore, due to significant currency adjustments across EMs in 2014, there may now be opportunities in select markets where currencies have weakened more than fundamentals would suggest, such as the Mexican peso, the Malaysian ringgit and the Indonesian rupiah. 3. JPMorgan GBI-EM Global Diversified index. Source: JP Morgan 4

5 What can be done to help mitigate and manage potential risks? The nature of EM local currency debt can provide an attractive risk-reward tradeoff and investors can at any time use a variety of instruments, such as inflation-linked securities and corporate bonds, to diversify risk and sources of returns. They can also use levers to help mitigate or manage risk, especially in conditions such as those we currently see. Currency volatility Currency is a key source of volatility in EM local currency debt strategies. This affected US dollar-based investors in However, for non-us dollar-based investors, the experience has not been nearly as severe given the breadth of the US dollar rally. In addition, EM local currency debt returns have historically been dominated by income and capital appreciation (see Exhibit 5). Investors can use hedging to help mitigate the risks of volatile currencies. This is most often a tactical decision, given that the cost of hedging can be significant. However, hedging may be used more strategically in markets with steep yield curves, where managers can still achieve a positive net yield after hedging, or in markets where positive rate movements are expected to generate gains on bond positions. Curve and duration positioning can also be used in countries where there is a positive view on rates but concerns over currency; investors can increase interest rate exposure by investing in longer maturity securities, rather than by increasing the country weighting, thus avoiding an increase in currency exposure. This flexibility would be especially useful in markets where the cost of hedging currency can be prohibitively high. A recent example of this was South Africa, where both a negative external balance and poor domestic fundamentals weighed on the currency, yet yields remained high. The impact of the 2014 sell-off in EM currencies exemplifies why EM exchange rate weakness should not be looked at in isolation from bond yields. Although EM currencies weakened against the US dollar, most local bond markets rallied in local currency terms. Exhibit 4: Development of the Mexican peso yield curve ( ) 12 Dec 2001 Dec 2003 Dec 2006 Dec 2009 Dec 2014 Yield to maturity (%) M 6M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 15Y 20Y 25Y 30Y Maturity (months/years) Source: Bloomberg 5

6 As well as boosting returns that were already benefiting from high levels of yield, the rally compensated for some of the known currency risk for US dollarbased investors. Markets with particularly high-yielding local bonds, such as Turkey, actually produced strong positive returns for dollar-based investors, despite the significant currency impact on results (see exhibit 6). Inflation-linked bonds In markets where inflation management is less of a priority or not well developed, there is often increased inflation risk for investors. However, inflation risks can actually offer an attractive risk-reward tradeoff. They are priced into securities and sometimes there is even a premium priced in by the market given uncertainty around inflation management. However, it can still be useful for investors to have risk management instruments for inflation in their portfolios. Managers are able to express a view on inflation in markets where inflationlinked securities (ILS) are available. To the extent that they disagree with the inflation view priced into nominal securities, they might prefer to buy ILS. For instance, if the implied inflation breakeven of nominal bonds is lower than their own expectations, ILS can offer a way to express a view that inflation will rise relative to expectations. Conversely, there may be times when the inflation priced into nominal bonds is higher than managers own expectations, and in those cases nominal bonds might offer relative value versus ILS. A country may choose to issue ILS in order to create local currency assets that are attractive relative to hard currency alternatives for a variety of reasons. It could help avoid the dollarisation of currency for countries with a history of high inflation, or reduce a country s exposure to foreign Exhibit 5: EM currencies have been a key driver of volatility but not long-term returns for EM local currency debt Total return Currency Capital appreciation/depreciation Income Dec 02 Aug 04 Apr 06 Dec 07 Aug 09 Apr 11 Dec 12 Aug 14 Returns from JPMorgan GBI-EM Global Diversified index, in unhedged US$ terms. Rebased to 100 at December Source: JPMorgan. As at 31 December

7 currency funding and volatile shortterm rates. As well as providing diverse funding sources, it could also reduce funding costs, while longer dated ILS are typically easier to sell than nominal. Additionally, for countries with a history of high or unmanaged inflation, there may be little investor appetite for nominal bonds. Investors would demand high compensation for unknown inflation. Therefore, those countries may find, particularly if they have a new commitment to reduce inflation, that inflation-linked bonds offer them a cheaper source of financing. Exhibit 6: Higher yields for many EM local currency bonds can compensate for some of the known currency risk Local return Currency return Total return for dollar-based investor Indonesia Turkey Thailand Philippines Peru South Africa Brazil Mexico Malaysia Romania Poland Nigeria Hungary Colombia Russia -60% -40% -20% 0% 20% Data as at 31 December Source: JPMorgan How can investors incorporate EM local currency debt into their investment strategy? As stated at the beginning of this paper, EM debt has evolved significantly as an asset class since becoming an investment option. In the early days, decisions on whether to invest were largely credit driven, based mainly on whether or not the issuer was likely to default. Now that the market has expanded and deepened, investors can find many more sources of return. They can choose from EM US dollar-denominated funds, and of course EM local currency debt funds. There is also the option of investing purely in sovereign debt, or corporate debt, or taking a blend approach. 7

8 The local currency component of EM debt should no longer be seen as a minor diversification option in the way it has been historically. Exposure to local currency debt through permitted diversification in a primarily EM US dollar-denominated debt mandate could prove suboptimal, as it would often be restrictive in terms of the weighting of local currency debt within the mandate. The other two options for investing in EM local currency debt would be either through a blended mandate, which includes both US dollar-denominated and local currency debt, or through a primarily local currency debt mandate. The blend approach would provide the flexibility to diversify between the two variants of emerging market debt, while a mainly local currency debt approach would provide the advantages discussed above. Either way, EM local currency debt can be a useful complement to other forms of debt in an investment portfolio. All information as at 6 March 2015 unless otherwise stated. This communication is intended for advisors and professional investors only, and should not be relied upon by retail investors. Past results are not predictive of future results. This information is neither an offer nor a solicitation to buy or sell any securities or to provide any investment service. While Capital Group uses reasonable efforts to obtain information from sources which it believes to be reliable, Capital Group makes no representation or warranty as to the accuracy, reliability or completeness of the information. This communication is not intended to be comprehensive or to provide investment, tax or other advice. It has been prepared for multiple distributions and does not take account of the specific investment objectives of individual recipients and it may not be appropriate in all circumstances. The information provided in this communication is of a general nature and does not take into account your objectives, financial situation or needs. Before acting on any of the information you should consider its appropriateness, having regard to your own objectives, financial situation and needs. This communication has been prepared by Capital International, Inc., a member of Capital Group, a company incorporated in California, United States of America. The liability of members is limited. In Australia, this communication is issued by Capital Group Investment Management Limited (ACN AFSL No ), a member of Capital Group, located at Level 18, 56 Pitt Street, Sydney NSW 2000 Australia. All Capital Group trademarks are owned by The Capital Group Companies, Inc. or an affiliated company in the US, Australia and other countries. All other company and product names mentioned are the trademarks or registered trademarks of their respective companies The Capital Group Companies, Inc. All rights reserved. 8