* Asset class posts 17% return this year
* Valuations compelling compared with US and Europe
* Investors need to beware local risks
By Robert Hogg
Sept 8 (IFR) - Emerging markets local currency debt has
woken from a two-year nightmare to post the year's outstanding
credit performance, although individual country and currency
dynamics mean the story is not universally positive.
Thanks to an energizing combination of inflows and a
supportive technical backdrop, the asset class has delivered a
total return of 17.1% as of September 7, according to JP
Morgan's GBI-EM Global Diversified index, making it the best
performing mainstream credit market this year.
In the emerging markets alone, the index has outperformed
the EMBI Global Diversified, which measures sovereign dollar
bonds, by 250bp. Against the Barclays Global Aggregate index,
the return is even more impressive, with an outperformance of
close to 700bp.
With recent economic data from emerging economies showing
signs of improvement - Moody's expects growth for G20 developing
countries of 4.4% this year and 5% for 2017 - and valuations for
local currency debt attractive, investors have returned to the
"Currencies have adjusted, nominal yields are high, and
anything dollar-denominated has become very expensive. All
natural conditions are in place for a rotation into local
currency," said Alan Cameron, economist at Exotix.
Local currency bonds have seen US$11.34bn of net inflows
this year, according to EPFR Global, compared with net outflows
of US$16.87bn in 2015 and US$12.83bn in 2014, as investors sniff
"Not only have EM currencies depreciated to close to their
20-year lows, but bond yields have also increased to the highest
levels since the 2008 crisis, in real as well as nominal terms,"
said Alexis De Mones, head of fixed income at Ashmore.
The average yield on the GBI-EM GD index is 6.17%, while
10-year Treasuries are at 1.54% and 10-year Bunds are negative
"Relative to US real interest rates, yields of emerging
markets local bonds on the GBI EM GD currently trade close to
all-time highs," De Mones said.
Still, there are potential risks, not least US rate hikes
and FX fluctuations, although investors believe that, given
valuations, EM currencies offer a means to add alpha.
"Given that currencies generally exhibit mean reverting
characteristics, the deviation from the historical average we
are seeing now suggests that an exposure to EM currencies could
potentially add to the return on EM local bonds," said Olga
Yangol, portfolio manager at HSBC Global Asset Management.
The outlook for local rates is also constructive. "There is
definitely room for EM central banks to cut rates," said Rob
Simpson, portfolio manager at Insight Investment. "At the same
time, growth is picking up. Russia and Brazil signaled rate
hikes but are now in cutting mode."
Some fund managers believe the asset class is only at the
beginning of a prolonged period of outperformance.
"We believe local bonds will deliver strong risk adjusted
returns in the medium to long term, and for investors concerned
with timing, we're in a particularly strong environment as the
asset class currently displays a combination of strong value and
momentum," said De Mones.
However, as the poor performance between May 2013 and
December 2015 shows - triggered by the taper tantrum and
continued thanks to the slump in commodity prices - investors
can get their fingers' badly burned.
Currently South Africa, for example, is proving volatile
thanks to political uncertainty. The rand has seen huge
fluctuations over the past month, trading in a range of 13.26 to
14.73 against the dollar. It is now at 14.03.
"South Africa is an interesting case," said Yangol. "There's
been an improvement in the trade balance. If we didn't read the
news and just looked at the fundamentals then it would be a key
candidate for adding exposure. But it's cheap for a reason."
(Reporting by Robert Hogg; editing by Sudip Roy and Alex