Emerging Market Debt: Local currency bonds
Emerging market debt (EMD) originated as a hard currency debt market but today it is the local currency issuance that dominates the sovereign debt marketplace, while hard currency issuance in 2007-08 was 70% corporate. Not surprisingly, the move towards local currency issuance is also reflected in the growth of local currency bond management by fund managers and in the fact that new searches by institutional investors for EMD managers are predominantly for local currency. "The beauty of local currency debt is that as countries improve and grind down in yields, new countries get developed and enter the universe at a yield of, for example, 12%," says Peter Eerdmans, head of the EMD team at Investec. "We have a universe of 40 countries that we follow, but there are another 150 countries out there that are not even covered."
Peter Marber, head of EMD at HSBC/Halbis echoes this view: "We believe that there is now enough economic momentum in emerging markets that there will be the opportunity to benefit from credit compression and currency appreciation for the next 10-20 years."
Of the $12bn of EMD managed by Pictet, 70% is now local currency, according to head of EMD Simon Lue-Fong. Just 18 months ago, the ratio was 30% local currency and 70% hard currency. This experience is mirrored by many firms and there has been a plethora of new local currency EMD funds launched in the past 18 months.
By contrast, Investec has focused on local currency since the inception of its EMD strategy five years ago, and the only hard currency debt they have is in crossover funds. "When we decided to have a flagship EMD fund the logical route was to have a local currency fund," says Eerdmans. "It fitted our expertise and view of the way that the markets would develop."
However, firms with longer experience in the EMD markets, such as HSBC, still retain a hard currency bias in their assets under management. While HSBC globally has around $40bn (€51bn) in EMD, the $6bn of global strategies managed by HSBC/Halbis from New York are predominantly hard currency, and a dedicated local currency strategy was only launched in 2007.
Franklin Templeton, with over $4bn of EMD, still does not have a separate local currency strategy (its global EMD fund has 65% in local currency, and just 25% in hard, benchmarked against a hard currency index).
What has characterised the growth of local currency debt is the development of local financial institutions such as insurance companies and pension funds throughout the developing world who are the natural buyers of sovereign bonds issued locally. As a result, as Lue-Fong points out, there are more natural buyers for local currency debt than hard currency so that when the credit crunch panic spread to the EMD markets in 2008, it was the dollar denominated debt markets that performed worse.
What appears to be happening is that hard currency sovereign issuance has been overtaken to such a large extent by local currency, that it is now looking anomalous to have a hard currency sovereign benchmark with the ability for managers to take local currency off-benchmark bets.
There may even be a case for having a local currency benchmark index and taking risk against it with hard currency off-benchmark positions. Clearly, such permutations all have their drawbacks and perhaps the clearest message is that index benchmarks are now straying so far away from managers' actual strategies that their usefulness can be questioned.