Yield Hunt Leads to Currency Debt
By ALEX FRANGOS And MARK GONGLOFF
The global rush for yield is driving investors to buy emerging-market debt issued in local currency, adding foreign-exchange fluctuations to the list of risks bondholders face.
The latest evidence came Monday when the Asian Development Bank reported that foreigners are taking an ever bigger chunk of debt issued in local currencies. U.S. investors, in particular, figure they can make money in two ways—on relatively high interest rates on emerging-market debt, and on any weakness in the U.S. dollar.
View Full Image
European Pressphoto Agency
Investors in search of higher yields are snapping up emerging-market debt issued in local currencies. Here, an Indonesian broker in Jakarta.
For emerging businesses or governments, the local-currency debt alleviates the currency risk of borrowing in dollars or other hard currencies.
Foreign investors as of the end of July held 27% of Indonesia's local-currency government debt compared to 16% a year ago. In Malaysia through June, it's 18% compared to 10% a year ago, according to the ADB.
Most believe that trend only accelerated in the third quarter. Standard Chartered economists figure foreign holdings in Thailand's local bond market nearly doubled since July to 265 billion Thai baht ($8.8 billion).
Investors have good reasons to buy emerging-market bonds for the long haul, including better growth prospects and stronger currencies than in the developed world, along with lower debt and deficit levels.
At the same time, some of the money pouring into emerging markets comes from investors taking advantage of rock-bottom interest rates in the developed world, particularly the U.S., to pick up easy profits by lending money at higher rates elsewhere.
But the risks are rising. Debt denominated in local currency makes it easier for the borrowers to pay back in the event of a financial panic in which their currencies weaken sharply. But in the scenario where currencies drop, so do the value of the bonds for foreigners.
Global investors have been flocking to emerging markets in recent months, pumping $39.5 billion into emerging-market bond funds this year, according to data provider EPFR Global, easily an annual record already.
Among the beneficiaries: Mexico, which has in the past defaulted on its dollar-denominated debt. Mexico now counts on its local-currency bond market to fund three-quarters of its borrowing needs.
Foreigners in recent months have been a big part of that demand, according to Jose Antonio Ordas Porras, head of global markets for BBVA in Mexico. He said he was recently on a tour of Asia, where demand for Latin American debt is strong.
"We've seen a move into buying Mexican debt in pesos, and that will continue. Local governments prefer to have debt in their own currencies rather than dollars. That was the sin of the past, the sin of the 80s," he said.
Local-currency emerging-market government bonds have returned almost 13.3% this year, according to Barclays Capital indexes, compared with 11.8% for U.S. high-yield bonds. The Dow Jones Industrial Average, meanwhile, closed Monday up 3.1% on the year.
"I can't think of many asset classes out there that are investment grade and liquid with those kind of returns," said Francisco Javier Murcio, deputy portfolio manager for emerging-market strategies at Standish Mellon Asset Management in Boston.
The demand for local currency bonds prompted the Philippines last month to issue $1 billion worth of peso bonds directed at global investors. The offering was oversubscribed by 13.5 times, according to Citigroup, enabling the Philippines to pay a yield of just 5%, while shifting the currency risk to the investors. Inflation in the Philippines, which in the past has run into double digits, is currently at 4%.
Investors are so bullish on the Philippines, Moody's Investors Service calculates that current bond yields imply the market thinks Philippines bonds should have an investment-grade rating of A3. Moody's actual rating on Philippines bonds is six notches below that.
Meantime, carry traders have been attracted to relatively high-yielding debt of relatively highly rated emerging-market countries.
Brazil's real-denominated 10-year sovereign debt, for example, yields almost 12%, compared with 2.5% for the 10-year U.S. Treasury note. Standard & Poor's rates Brazil's local long-term debt BBB+, well into investment-grade.
Helping drive investors to local-currency debt: it typically yields more than dollar-denominated debt.
These days the risk premium over Treasurys for BBB-rated emerging-market sovereign debt is smaller than that for U.S. investment-grade corporate bonds, according to Bank of America Merrill Lynch indexes.
Brazil and Russia this year have sold dollar-denominated 10-year debt at record low yields of just 5%.
Little wonder that half of the billions flowing into emerging-market bond funds lately are going into higher-yielding local-currency debt, according to EPFR Global.
These funds are small relative to what could be $575 billion in capital flowing to emerging markets a year, according to a recent Goldman Sachs estimate. But that "wall of money," as Goldman called it, raises risks for bondholders.
An influx of foreign cash creates headaches for local policy makers fighting inflation and trying to keep their economies from spinning out of control.
In the past year, governments throughout Asia and Latin America have either threatened or taken steps to weaken their currencies and stem the tide of cash.
These efforts typically aren't effective, many analysts note, but they are a risk for foreign investors, sometimes involving taxes or other penalties.
Yields are high in these countries partly to compensate for the risk of unfriendly government policies, along with choppy currency moves and other uncertainties.
Brazil's local-currency 10-year bond yields surged by 0.33 percentage point last week, and prices dropped, after Brazilian Finance Minister Guido Mantega complained of an "international currency war" and spoke of steps to weaken the real.
Arguably the hottest money flowing into emerging markets goes to stocks and real estate, where the payoffs are bigger. But bondholders could suffer the repercussions if and when those frothier markets go bust.
Philip Poole, global head of macro and investment strategy for HSBC Asset Management in London, doesn't think local-currency bonds are in a bubble yet, but the potential is there, he says.
"Money is being delivered from deep liquid markets in the West to relatively shallow markets in the emerging world," he says. Unwanted capital flows into small economies can lead to inflation, policy mistakes and overinflated markets, with the end result a "substantial bubble," Mr. Poole said.
"Clearly people have to bear in mind currency risk can lead to very rapid losses," he said.
Write to Alex Frangos at firstname.lastname@example.org and Mark Gongloff at email@example.com