Since the dark days of the 1997 East Asian financial crisis, commodity-led growth, healthy foreign exchange reserves and more-prudent fiscal and monetary policies have made emerging markets an object of affection among global fixed-income managers. Dollar- and euro-denominated bonds have rallied accordingly, with the benchmark JPMorgan EMBI global index delivering average annual returns of 14.11 percent from 1998 through 2006. Now, with strong price appreciation dramatically compressing spreads over U.S. Treasuries, emerging-markets bond managers seeking higher yields are turning to the growing market for local currency debt.
"Local currency investing today is where U.S. dollar emerging-markets debt was five to seven years ago," says Gunter Heiland, co-head of emerging-markets debt at JPMorgan Asset Management Holdings, which has been adding these bonds to many of its global fixed-income offerings. The $128 million-in-assets JPMorgan Emerging Markets Debt Fund invests about 27 percent of its assets in locally denominated securities. Heiland has also been converting external currency mandates to local currency portfolios to meet clients' higher return targets.
Several U.S. mutual fund companies are creating new offerings. In January, Newport Beach, California based Pacific Investment Management Co. launched a second local currency fund, available only to institutional investors, the Pimco Emerging Local Bond Fund, which has $92 million in assets and a target duration of about four years. T. Rowe Price Group, which has been adding local currency bonds to its $603 million Emerging Markets Bond Fund, will launch a stand-alone fund later this year.
Higher yields aren't the only attraction. Short-term, local currency instruments are negatively correlated with U.S. Treasuries and the Lehman Brothers aggregate bond index, and longer-duration local currency issues have only moderate correlations. "Local currency debt provides great risk diversification," says Jerome Booth, head of research at London-based Ashmore Investment Management, which manages $6.5 billion in local currency fixed income and has run an open-ended, Guernsey-registered local-currency emerging-markets debt fund since 1997. "That's why pension funds and other institutional investors love it," he adds.
Given the inherent currency and political risk, investors have been reluctant to buy long-dated emerging-markets securities, so opportunities have traditionally been at the short end of the yield curve. A case in point is the Pimco Developing Local Markets Fund, the first U.S. mutual fund dedicated to local-currency emerging-markets debt -- and now the biggest, with $3.7 billion in assets. Launched in May 2005, the fund invests primarily in forward currency contracts and has an average duration of just four months. Last year the fund returned 11.5 percent and ranked in the top quintile of international income funds as tracked by Lipper. Still, it fell shy of its benchmark, the JPMorgan emerging-local-market index plus, by nearly 1 percentage point.
Portfolio manager Michael Gomez, co-head of emerging markets at Pimco, is overweight countries that have minimal external financing needs and strong reserves, like Brazil and Russia. He is avoiding those, like Turkey and Hungary, that have large fiscal deficits and are heavily dependent on foreign financing.
At 5 percent of the Pimco fund's portfolio, the Russian ruble has been a core position since early 2006. Because Russia is running current-account and fiscal surpluses yet faces incipient inflation, Gomez figures authorities will tolerate more currency appreciation. Last year the Russian currency returned 14.58 percent to U.S. dollarbased investors.
With an overweight 5 percent position in Asian currencies, Gomez is also playing a long-term decline in the U.S. dollar. He asserts that as economies in the region mature and domestic consumption begins to drive a bigger share of growth, Asian governments will become more tolerant of currency appreciation.
Two trades involving Brazil's currency have generated big profits. Throughout 2006, Gomez sold dollars and bought currency contracts for the real, which returned 26.94 percent to U.S. dollar investors last year. Late in the year he also entered Brazil's interest-rate-swap market by snapping up a January 2010 interest rate futures contract yielding a fixed rate of 14.20 percent a year. As the Brazilian central bank cut its overnight lending rate, Gomez's carrying costs have fallen, but the rate on his investment remains the same. This trade has returned an annualized 15.1 percent since September.
Ashmore tends to keep its local-currency debt fund on a short leash. With an average duration of 18 months, the Ashmore Local Currency Debt Portfolio returned 12.17 percent in the three years ended December 2006, compared with 9.99 percent for the JPMorgan emerging-local-market index plus; the fund employed leverage equal to 29.7 percent of its assets.
Lately, the fund has been overweight Central and East European debt instruments, which constitute 32 percent of its portfolio. Currencies in the Czech Republic, Hungary, Poland and Slovakia have all appreciated on the back of a strong euro. Trades in Brazil have also contributed to the fund's outperformance versus its benchmark. "We expect local currency debt to benefit from continued upward currency pressure in these markets in 2007," says Mark Weiller, a New Yorkbased director at Ashmore.
Some portfolio managers see opportunities further out on the yield curve. The average effective duration of the JPMorgan Emerging Markets Debt Fund, for instance, is 7.1 years. "We're buying actual bonds," says Heiland, who comanages the fund with Jeffrey Grills. "If all you're buying is very short rates locally, you're missing the broader opportunities."
The managers say longer-dated securities offer attractive valuations. As of January 19, yields on JPMorgan's local currency and external currency indexes were practically the same, about 6.44 percent and 6.51 percent, respectively. But the duration of the bonds in the local currency index was only 4.43 years, versus 7.12 years for the external debt index. "You're getting a higher yield on shorter maturity instruments," says Grills.
Their fund, which outperformed the JPMorgan EMBI global index in the one-, three- and five-year periods ended December 2006, has enjoyed recent strong performance in key Latin American and Asian positions. In Brazil, where the fund has a 6 percent allocation, Heiland and Grills own BRL 16s issued by Goldman, Sachs & Co. and JPMorgan Chase & Co. that are linked to the real but settle in U.S. dollars. The bonds carry a 12.5 percent coupon and mature in 2016. In 2006, as the central bank cut rates and the real rallied, local currency Brazilian bonds as represented by the JPMorgan EMBI global index's Brazil subcomponent generated returns of 39.29 percent.
The JPMorgan fund's 4 percent allocation to local currency bonds in Indonesia was another significant contributor to performance last year. In early 2006, with interest rates spiking following the government's 2005 decision to abandon oil and gas subsidies, Heiland and Grills bought credit-linked notes issued by Deutsche Bank that are invested directly in Indonesian government bonds. The securities are due in 2018 and carry an 11.6 percent coupon. As a result of central bank cuts in the overnight bank lending rate throughout the year, the interest rate spike subsided, and Indonesian bonds rallied by 46.01 percent in 2006. In contrast, comparable U.S. dollardenominated Indonesian debt returned 15.95 percent last year.
Michael Conelius, who manages T. Rowe Price's Emerging Markets Bond Fund, uses local currency bonds to make bets on improving fundamentals and has returned an annualized 15.68 percent over the past five years. "We primarily invest in countries where we see real rates falling and prospects for credit improvement," he says. The fund has 15.5 percent allocated to local currency debt: 4.5 percent in Brazil, 4.5 percent in Turkey, 3 percent in Mexico, 2.5 percent in Argentina and 1 percent in Egypt. Conelius expects upgrades in Argentina, Brazil and Mexico in 2007.
Despite the attractions of local-currency emerging-markets bonds, there is plenty of downside risk. Last summer, for instance, local currency issues were hit particularly hard when investors fled risky assets based on fears that the U.S. Federal Reserve Board would continue to raise short-term interest rates. The JPMorgan EMBI global index, which is U.S. dollarbased, fell 2 percent from May to June, whereas JPMorgan's local-currency global bond index for emerging markets dropped by nearly 9 percent.
"You can still see investors trying to get out the same small door," says Matthew Ryan, who manages MFS Investment Management's $240 million MFS Emerging Market Debt Fund, which holds 15 percent of its assets in local currency debt.
As local debt markets mature, though, liquidity will improve. Barring a crisis, fund managers and their yield-starved investors are sure to continue embracing new supply. "Structurally, this is where the market is going," says T. Rowe Price's Conelius.