Emerging Markets Local Fixed Income Poses More Risk Than Many Perceive
These assets comprise both a bond and a currency component. Investors should take two separate decisions and hedge the foreign exchange exposure to maximize returns.
By Adrian Lee
Local fixed-income securities issued in the emerging markets have become increasingly appealing to institutional investors seeking higher returns and diversification benefits. These markets strong fundamentals, their growing economic weight and sound fiscal management and the possibility of enhanced gains on both the underlying debt and appreciating currencies make for a compelling case.
The reality is more nuanced. Emerging-markets currencies can be volatile in the short term and subject to depreciations that can wipe out positive returns generated by local currency bonds. In fact, the currency risk is more than twice the underlying bond risk.
In 2011, for instance, the Polish bond market returned 6 percent, a reflection of solid local economic and fiscal fundamentals, but the Polish złoty fell by 14 percent against the dollar, hit by the European debt crisis and flight-to-safety flows. As a result, U.S. investors holding Polish sovereign debt would have incurred a net loss of 8 percent. ....