Investors buy local currency bonds as dollar debt loses its appeal

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Investors are investing money in emerging market local currency bonds, as high interest rates and declining inflation make them increasingly attractive relative to dollar assets.

In the first four months of the year, investors withdrew $2.65 billion net from funds holding so-called hard-currency emerging-market bonds, mostly denominated in dollars, but added $5.23 billion to bond funds in local currency, according to fund flow data provider EPFR Global.

The flows mark a reversal of years in which investors opted for dollar-denominated debt as a strong greenback has generally generated better, lower-risk returns. This year, that has changed with local bonds outperforming as currencies including the Mexican peso and the Brazilian real have strengthened more than 10% versus the dollar.

“Local markets are far outpacing external debt,” said Paul Greer, emerging markets debt portfolio manager at Fidelity International. “Frankly I think that trend will likely continue for the rest of the year.”

JPMorgan’s emerging markets benchmark for local currency this year state bonds it delivered a total return of 6.8%, outpacing its hard currency counterpart’s 1.9% increase.

Analysts say much of this outperformance is due to the dollar weakening this year against many major developing country currencies which also offer higher rates of return. Such a rise in the exchange rate is known as a “carry” in the foreign exchange markets.

“The carry trade is front and center in people’s minds,” said Manik Narain, chief emerging markets strategist at UBS. “There is a strong consensus to be short the dollar, on the grounds that the Fed has reached the end of its tightening cycle.”

Jay Powell, the chairman of the Federal Reserve, yes indicated that the central bank was preparing to suspend another rate hike next month. However, he was more cautious about when the rate cuts will start.

Kamakshya Trivedi, head of global foreign exchange, rates and emerging markets strategy at Goldman Sachs, said investors are still excited about the trade.

“The view is that with the Fed on hiatus, this should reduce interest rate volatility and create room for investors to earn the risk premium offered in specific high-yield emerging market pairs,” he said.

While some analysts believe emerging market currencies will struggle to continue outperforming the dollar, especially amid concerns about the US debt ceiling or a US recession, many continue to see reasons to hold local currency bonds.

“Over the past few quarters, we have seen a clear divergence between emerging market local and hard currency bonds, with local currency debt looking more attractive on a fundamental and valuation basis,” said Thanos Papasavvas, chief investment officer at ABP Invest.

Many emerging market central banks started raising interest rates before the Fed and were able to tame inflation more quickly. For countries where interest rates remain high, this has improved the real returns offered to investors.

In Brazil, for example, the official interest rate has been 13.75% since last August, while the April inflation data showed an annual price increase of 4.15%. In Mexico, the official rate rose to 11.25 percent in April, while annual inflation fell to 5.3 percent.

In addition to attractive emerging market real yields, the Fed is widely believed to have concluded its rate-hiking cycle with markets pricing in cuts of about 0.7 percentage point before the end of the year.

“Previous hiking cycles, falling inflation and signs that the US tightening cycle has peaked have presented an opportunity for local emerging market debt rates,” said Steve Ryder, senior portfolio manager at Aviva Investors.

“We like to be overweight Mexican bonds both outright and relative to the US as we believe the central bank is also close to peak interest rates and, with inflation expectations continuing to fall, we believe the case for rate cuts rates are rising,” Ryder said. Falling interest rates cause bond prices to rise and yields fall.

Goldman picked Brazil, Hungary and Mexico as its chosen “carry candidates” and warned of the South African rand, which hit an all-time low against the dollar last week after the US accused South Africa of supplying arms to Russia in a covert naval operation.

However, many investors remain cautious about the outlook for emerging market assets, with positioning still low by historical levels.

“Confidence is very low,” said David Hauner, head of cross-asset EM strategy at Bank of America Global Research. “People are very long cash and wait for trends to emerge.”

Like UBS’s Narain, he said some investors had an overly rosy view of the outlook for US rate cuts, which the BofA did not expect to begin until next year.

Even so, he said, the question now was when, rather than if, the Fed would start cutting.

“Inflows into emerging market local currency debt will start to accelerate as there is more confidence in the start of the Fed’s cutting cycle,” he said. “Everyone is waiting for that green light.”