Colchester believes that local currency EM government debt is particularly attractive today for both strategic asset allocation (in terms of capital preservation, liquidity and return), and tactical reasons (it offers attractive valuations at this juncture). Whilst hard currency EM sovereign debt has historically generated attractive returns, its characteristics are less conducive to the objectives of safety (i.e. capital preservation) and liquidity, given the lower credit ratings and poorer liquidity in this space. In the following analysis, they show that current valuations of the hard currency EM debt asset class are less attractive than those prevailing in local currency space:
Our analysis suggests that the US dollar remains fundamentally overvalued in real terms against many developed and emerging market currencies. The recent relative weakness in the US dollar may be the beginning of a significant depreciation, and if this is the case, historically such a backdrop has been a positive environment for EM assets. Such a depreciation would also benefit non-USD EM assets. With US interest rates depressed, and monetary policy unlikely to shift gears any time soon, the incentive to deploy capital in EM is strong, in the absence of significant negative shocks.
Our stance on the relative attractiveness of EM currencies is further underpinned by the strength of the external position of many economies compared to history. A vulnerability to external shocks and capital outflows has historically been a characteristic of EM economies, but at present we believe that such vulnerabilities are low - at least in the major issuers of local currency EM government debt
In our opinion, local currency EM debt offers structurally higher liquidity and lower credit risk. The diversification benefits are also somewhat better. Global factors tend to have more of an influence on hard currency debt markets while domestic drivers tend to impact more on local currency debt markets. Lastly, the cyclical outlook favours local currency assets given (i) the relative undervaluation of the currency component, as the US dollar remains fundamentally overvalued against most global currencies; and (ii) the accommodative stance of monetary policy in developed markets continues to act as a “push factor” for capital to seek higher returns in emerging markets.
Historical Returns and Correlations
Historically both EM hard and local currency debt (unhedged) have generated meaningfully higher returns than traditional defensive fixed income assets such as US Treasuries, albeit with higher volatility. The local currency asset class has comfortably outperformed US Treasuries, global developed market government debt, and US corporate debt since the inception of the standard index for local currency EM debt at the end of 2002. Hard currency debt has performed even better over this time period, generating similar returns to that of high yield corporate debt. Unhedged local currency EM debt has historically generated more volatile returns than hard currency EM debt. This is a function of exchange rate movements.
Furthermore, the diversification merits offered by local currency EM debt appear to be superior to that offered by hard currency EM debt, given its historically lower correlation to US Treasuries, investment grade corporate, and high yield corporate debt. Hard currency bonds are typically held by global investors and are valued and priced by the market as a credit spread relative to the US Treasury curve (as USD-denominated debt comprises the majority of this asset class). Local currency EM bond markets on the other hand, are typically dominated by domestic investors, and are therefore less sensitive to changes in global financial conditions and more sensitive to domestic economic conditions.
Both USD- denominated EM hard currency debt and US corporate debt are priced as a spread relative to US Treasuries. As US Treasury yields are close to historical lows and offering deeply negative real yields at present, and the yield on the standard EM hard currency index is also, not surprisingly, close to its historical lows. It is also questionable whether a nominal yield of around 4.5% sufficiently compensates for the underlying credit risk in the hard currency EM debt asset class.
Hard currency EM debt spreads widened meaningfully in early 2020 but have already retraced most of the maximum deviation from the average credit rating spread, with the “gap” relative to US Treasuries down to a relatively modest 60bps. This needs to be weighed against the increased default risk that has also risen materially over 2020. A number of issuers have already defaulted, and around 5% of the index by market value was trading at distressed levels at the end of 2020 i.e. with spreads of over 1,000bps. This suggests that the apparent attractiveness of the spread should be discounted by this changed default and stressed environment.
A closer look at the spread on the investment grade (BBB- and higher) segment of the index in isolation provides an insight into this effect. Instructively, the current level of spread is below the average of the past five and ten years, and is close to the lows observed in 2012, 2017 and 2019. This suggests that the relatively less risky segment of the index (i.e. with lower probability of default) is currently not offering compelling value. It also suggests that the spread on the index itself is being boosted by the lower-rated more speculative credits – hinting at a case of “spread illusion”.
Similarly, the nominal yield on the index itself, at 4.55% as at 31st December 2020, is somewhat boosted by the high spreads and the higher yields in these more distressed markets. The yield on the investment grade segment, which makes up over 50% of the total index, was only 2.72% as at the end of 2020.
Turning to local currency EM debt, Colchester values local bond markets in terms of their relative prospective real (i.e. inflation adjusted) yield, and currencies in terms of their real exchange rates. The bond element is simply the weighted average prospective real yield. In other words, the nominal yields in each market adjusted for Colchester’s forecast of future inflation. The currency element is the index weighted percentage over- or under-valuation in real terms relative to the US dollar, divided by -5. The over- or under-valuation is estimated by calculating the real exchange rate for the currency and comparing that to a measure of long-term equilibrium or “fair value”.
Combining today’s bond and currency valuations suggests that local currency EM debt is attractively valued compared to history. Whilst not at its widest observed valuation points, the intrinsic real value compares favourably to history.
This is largely due to EM currencies being generally undervalued in real terms today. By Colchester’s estimates the weighted average real exchange rate of the local currency index is 11% undervalued against the US dollar. Whilst currency valuation gains may be the largest potential contributor to potential returns today, potential bond returns are also making a meaningful contribution.
Capital Preservation and Liquidity
- Default Probability
Local currency debt has a lower default rate across the board. Intuitively we would have expected this. Sovereign issuers typically have the unique ability to create (“print”) the currency of denomination of the bond, as well as an ability to raise taxes from their domestic economies to meet financing and servicing needs. Governments also face pressure from their local population, who vote, or implicitly have the power to remove those in government. It is therefore not surprising that, as most local currency EM debt is held domestically, there is a greater willingness to default on foreign rather than domestic creditors at a point of stress.
- Credit Rating
Given the higher default probability on hard currency EM debt, asset allocators need to be aware of the different rating profiles of both EM fixed income sectors when comparing the two. Not only is the probability of default lower in local currency debt, the credit rating of the standard local currency EM index (JP Morgan GBI-EM Global Diversified) has a demonstrably higher rating profile than its hard currency counterpart (JP Morgan EMBI Global Diversified). The higher credit rating enjoyed by local currency debt is not surprising as economies with more stable currencies and inflation, as well as deeper domestic capital markets, tend to issue more debt in local rather than hard currency. Many of those countries included in the local currency index issue around 90% of their debt in local currency.
Liquidity is the final characteristic asset allocators need to consider. When we compare the depth and liquidity of each market, we observe that the local currency universe is significantly larger and more liquid. Currently, the market value of EM local currency government debt is estimated by the Institute of International Finance, to be around USD 14 trn, whereas the stock of hard currency debt is estimated at only USD 1.3 trn. This large and widening discrepancy is not surprising, as countries have an incentive to reduce their external vulnerability by developing local capital markets and issuing in domestic currency. This reduces their exposure to external shocks, a flight of capital, and a potential shortage of foreign currency to meet funding needs. The three largest issuers of government debt within the EM universe - China, India and Brazil - each issue more than 90% of their government’s debt in local currency.
The depth and liquidity of the local currency EM government bond universe has been significantly enhanced by the opening of the Chinese local bond market to foreign investors in recent years. Local Chinese renminbi (yuan) denominated government bonds offer liquidity (the market is over USD 7 trn in size), a relatively high credit rating, and a negative correlation to risk assets.
Additionally, the opening of the domestic Indian government bond market to foreign investors is also accelerating. It too offers lower correlations with other global bond markets and asset prices. India is expected to be admitted to various EM bond indices in the not too distant future, further enhancing potential return and diversification characteristics of the local currency EM debt asset class.
This article should not be relied on as investment advice. Colchester Global Investors Limited is regulated by the UK Financial Conduct Authority, and only deals with professional clients. https://www.colchesterglobal.com for more information and disclaimers.