Investors are buying up local currency bonds as dollar debt loses its appeal

Investors are pouring money into emerging market local currency bonds as high interest rates and falling inflation make them increasingly attractive compared to dollar assets.

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

The flows indicate that investors have been choosing dollar-denominated debt for years because the strong greenback has generally produced better and lower-risk returns. The tables have been turned this year with local bonds outperforming as currencies including the Mexican peso and the Brazilian real gained more than 10 percent against the dollar.

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

This year, JPMorgan’s emerging market benchmark for government bonds issued in local currency returned a total of 6.8 percent, outpacing the hard currency’s 1.9 percent gain.

Analysts say much of the outperformance is due to the fact that the dollar has weakened this year against the currencies of many major developing countries, which also offer higher yields. In the foreign exchange markets, such an increase is called a “carry”.

“The carry trade is on people’s minds,” said Manik Narain, emerging markets strategist at UBS. “There is a strong consensus on the dollar as the Fed reaches the end of its tightening cycle.”

Federal Reserve Chairman Jay Powell has indicated that the central bank is preparing for another rate hike next month. However, he was more cautious about the timing of interest rate cuts.

Kamakshya Trivedi, head of global foreign exchange, exchange and emerging markets strategy at Goldman Sachs, said investors remain interested in trading.

“The view is that with the Fed pausing, it will reduce interest rate volatility and give investors some room to capture the risk premium offered in higher-yielding emerging market currencies,” he said.

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

“We have seen a clear divergence between emerging market local and hard currency bonds over the past few quarters as local currency debt has looked 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. In countries where interest rates remain high, this has improved the real returns offered to investors.

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

In addition to attractive emerging market real yields, the Fed is believed to have cut its rate hike cycle by about 0.7 percentage points before the end of the year.

“Past upcycles, falling inflation and signs of a peak in the US tightening cycle have provided an opportunity for emerging market debt rates,” said Steve Ryder, senior portfolio manager at Aviva Investors.

“We like to be overweight Mexican bonds both outright and the U.S. as we believe the central bank is also near the top on interest rates and as inflation expectations continue to decline, we believe the need for rate cuts is increasing,” Ryder said. . As a result of falling interest rates, bond prices rise and yields fall.

Goldman singled out Brazil, Hungary and Mexico as “carrier candidates” and warned against the South African rand, which hit a record low against the dollar last week after the United States accused South Africa of supplying weapons to Russia in a covert naval operation.

Still, many investors remain cautious about the outlook for emerging market assets, as the position is still low relative to historical levels.

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

Like Narain at UBS, he said some investors were overly rosy about the prospect of a U.S. rate cut, which BofA did not expect before next year.

Still, he said, the question now is more about when the Fed will start tapering.

“EM local currency debt inflows will begin to accelerate as confidence builds ahead of the start of the Fed’s cutting cycle,” he said. “Everybody’s waiting for that green light.”