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EM bonds, hard and local currency issuers

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Emerging market (EM) bonds over the years have increased in their popularity amongst investors, as we saw new entrants (in the form of bond issuers) to this segment both from a sovereign but also from a corporate perspective. That said we have also seen an increase in local currency denominated EM debt issuance. Domestically, investors are conversant with such asset class which, all in all, have over the years returned remarkable returns, with few exceptions.

EM debt is very sensitive to currency moves, inflation moves and geopolitical issues. Moreover, local currency EM debt is susceptible to higher volatility and lower liquidity in comparison to their hard currency counterparts. This is the reason why technically local currency EM debt should compensate investors more than dollar denominated EM issues. Historically this was the case.

Ironically, looking at the current scenario local currency EM debt is yielding less, than dollar denominated debt, which in theory are considered safer. History showed that usually local currency EM debt offers between 90-100 basis points higher than the dollar counterparts. Now according to the JP Morgan EM local currency index is yielding 6.69 percent, while is dollar counterpart is yielding 6.81 per cent.

The surprising discrepancies in yields might been seen as an anomaly by investors. However, looking at the recent trend being posed by the Federal Reserve (Fed), one should not be surprised by these movements. The message is clear, the path of interest rate hikes will be sustained given the maintained low unemployment and close inflation. This in turn has pushed benchmark yields higher. In my view, this is one of the main reasons for the higher EM dollar denominated yields. In reality, investors are demanding a higher premium and this is why over the past two weeks we have seen companies pulling out from the market as yields surged quite remarkably, particularly during mid-October. For instance, few months ago JBS, the Brazilian company which is considered the largest meat producer worldwide, succumbed to investors’ pressure, who demanded a higher yield, despite the improvement in credit metrics.

It is interesting to determine the anomaly as to why EM local currency bonds have to a certain extent been contained in terms of yields. My view for such anomaly is the very weak inflation data numbers we have been seeing on average in selective EM countries. It is the cause for this lower yield in local currency EM bonds. On low inflation numbers, Central Banks tend to ease their monetary position by amongst others keeping a low interest rate environment, which in turn is a positive for bonds.

Given the identical levels of yield, at this point I think it’s all about an investor’s currency view. If as an investor, you believe that from now on the dollar will weaken, EM bonds are offering very attractive relative values. Interestingly enough is the fact, that currently spreads for EM hard currency debt over U.S. Treasuries are twice as much those immediately before the financial crisis.

Given our belief that the trade war issue will be ultimately resolved, a long pending issue which rattled financial markets in 2018, the dollar will weaken, while EM local currencies and EM bonds will rally. Once again, I reiterate the fact that EM fundamentals are nowhere close when compared to the tapering tantrum in 2013. Today the fundamentals are more in shape. Take the dip in this volatile market.

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