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EM local currency investing

Investor risk appetite brings new players to an expanding opportunity set

Emerging market debt saw record inflows across 2016 and 2017 as income seeking investors sought higher returns in reaction to the bleak yield landscape across much of the developed market (DM) universe.

Local-currency denominated assets did particularly well in this context, with the JPMorgan GBI-EM Global Diversified index returning 25% from February 2016 to December 2017. This relatively new asset class is rapidly expanding from a base of around 17 markets, presenting, in our view, a number of interesting developments for investors from both return and diversification perspectives.

Holding restrictions around China’s local bond market were eased in 2016 with the launch of the China Interbank Bond Market scheme (CIBM). BlueBay is at the forefront of CIBM developments, being one of the first institutions worldwide to be granted a license to access the market to-date. At an excess of US$ 7 trillion in size, and with foreign investors currently holding only around 5% of this, the opportunity set appears very attractive to us.

Argentina has also expanded its debt offering, having implemented a programme of striking political and economic transformation. Now readily accessible to the international investment community, Argentina’s attractive yields make it one of the gems of the EM debt universe.

Egypt is another market that has gone through significant reforms, following the military coup in 2014. Aided by IMF support and efforts to de-peg the Egyptian pound, our rigorous on-the-ground due diligence has highlighted select pockets of opportunity.

We believe tactical trade potential is also present in Nigeria, when approached using detailed due diligence processes to counter economic and corporate governance challenges.

The local currency corporate debt market is an area of increasing interest within the emerging market (EM) universe. For mainstream EM countries, which have an established local currency sovereign market and seasoned local currency benchmark curve, we have seen a rising number of corporates seeking to take advantage of an investor base willing to increase their tactical allocation to this sub-sector.

This rapidly expanding opportunity set leads an investor to re-examine the structural case for local currency debt. In our view, the local currency market rally witnessed over the last 20 months has been firmly rooted in fundamentals, and further aided by broader risk-on sentiments towards emerging markets. We believe there are a number of factors that put EM local currency debt on a firmer footing today, potentially paving the way for a multi-year recovery, some of which are:

  • A combination of higher growth and lower inflation
  • Improved current account deficits
  • Attractive real and nominal yields
  • Cheap valuations of EM currencies

As fixed income investors, we are very mindful of the risks facing this asset down and we would highlight three core risks:

  1. G3 central bank balance sheet reduction
  2. China leverage build up
  3. Busy election calendar and increased geopolitical risk

On balance, the positive structural case for EM local currency debt should outweigh periodic corrections within the asset class. Our bias would be to add on weakness to take advantage of the positive structural story.