Emerging Local Funds Trail Dollar Debt First Time Since 2007
For the first time since at least 2007 investors are favoring emerging-market dollar bonds over local debt from the same nations as economic slowdowns weigh on the real, Indian rupee and Mexican peso.
Funds investing in developing nations’ domestic securities took in a net $2.9 billion this year through April 18, less than half the $7.3 billion placed in their dollar bonds, according to data compiled by Cambridge, Massachusetts-based research firm EPFR Global. Over the last five years, inflows to the domestic funds were $6 billion higher on average and the local securities delivered an average annual return of 9.8 percent in dollar terms, 1 percentage point more than the global bonds.
The shift is a warning sign to Amundi Group and Gramercy that investors are turning bearish on emerging markets, where currencies in Colombia and Hungary gained more than 10 percent against the dollar this year. Weaker demand for local debt may raise financing costs from Turkey to Indonesia just when China’s economy, the world’s second-largest, grows at the slowest pace since 2009 and Europe’s debt crisis shows signs of worsening.
“There’ll be more pressure on local markets and currencies in the near term,” said Jeff Grills, who helps oversee more than $2.9 billion of assets at Greenwich, Connecticut-based fund Gramercy. “The risk from external shocks is still very high given what’s happening in Europe and China. We are still cautious on local markets.”
Local-currency bonds in emerging markets climbed 0.4 percent this month through yesterday in dollar terms, after an 8.3 percent gain in the first quarter that marked their best start to a year, according to JPMorgan Chase & Co.’s GBI-EM Global Diversified Index. India’s rupee, Brazil’s real and Mexico’s peso lost at least 2.8 percent in April. Developing nations’ dollar-denominated bonds gained 1.1 percent since March, after advancing 4.9 percent in the last three months.
Economic growth in China, the world’s biggest buyer of Brazilian iron ore and Chilean copper, slowed to 8.1 percent in the first quarter as Europe’s debt crisis hurt exports and lending curbs cooled the housing market. Expansion averaged 10 percent in the last five years, official figures show.
Europe’s debt crisis is escalating after a three-month respite as Spanish 10-year bond yields rose above 6 percent this month, approaching the 7 percent level that led to bailouts for Greece, Ireland and Portugal. In the U.S., economic indicators are falling short of economists’ expectations for the first time since October, according to a Citigroup Inc. index.
“We are in a market that is quite shaky,” said Phillip Blackwood, who oversees $2.9 billion in emerging-market debt as a managing partner at EM Quest Capital LLP in London. “On the currency side, we are not at levels that we would say are cheap yet. There’s further to go.”
In the options market, traders are expecting swings in emerging-market currencies to pick up. The three-month implied volatility on options for the real, which reflects investors’ expectations for future price swings, was 5.3 percentage points higher than realized volatility, which tracks historical fluctuations, on April 19, according to data compiled by Bloomberg. That’s the biggest gap since September. A measure of rupee volatility reached the highest level since October.
“Investors are not comfortable with the currency risk,” said Thomas Delabre, who helps oversee about $1 billion in emerging-market debt at Amundi in London. “The market is very cautious and investors want to protect the downside.”
Local-currency bonds are still attractive because the global slowdown will prompt Brazil and Mexico to cut interest rates, while deterring Poland from raising borrowing costs, according to Jaime Valdivia, the head of global emerging-market research at Bluecrest Capital Management in New York.
Brazil’s central bank signaled last week it may cut its benchmark interest-rate to a record low after reducing it 3.5 percentage points since August to 9 percent. Mexico’s policy makers may “adjust downward” borrowing costs for the first time since July 2009 should inflation stabilize, according to the minutes published March 30.
“Conditions in Europe will help central banks take a less aggressive stance in terms of policy adjustments,” Valdivia said. “Those central banks that want to raise rates will think twice.”
The slowdown in inflows into developing nations’ local- currency bonds is unlikely to last, according to Kjetil Birkeland, a senior analyst in Boston at Standish Mellon Asset Management, which oversees $12 billion of emerging-market debt.
“There is room for emerging-market currency appreciation as economic fundamentals continue to support the asset class, including positive growth differentials versus advanced countries,” he wrote in an emailed response to questions. “In an environment where developed market global rates remain depressed and debt dynamics are worrisome, we expect to see a structural demand for higher-yielding local-currency debt.”
The average yield on local-currency bonds declined 24 basis points, or 0.24 percentage point, this year to 6.33 percent on April 24, while that for dollar-denominated securities fell 57 basis points to 5.51 percent, JPMorgan indexes show. The 82- basis-point yield difference compares with an average gap of 61 over the past year.
Investors pulled $3.9 billion from local-currency bond funds in the final four months of last year amid concern that Greece would default on its debt. The withdrawals helped push up borrowing costs in Turkey and South Africa, which rely on investment inflows to offset current-account deficits. Ten-year bond yields for Turkey rose 97 basis points to 9.91 percent during the period, while those for South Africa increased 11 basis points to 7.95 percent.
“It might become difficult for countries like Turkey” as investors withdraw money from local debt funds, said Kieran Curtis, who prefers dollar bonds in the emerging-market funds he helps oversee at Aviva Investors Ltd. in London.
Emerging-market local bond funds attracted $32 billion in the 11 quarters through September, according to EPFR, as currencies such as the real, Chile’s peso and Indonesia’s rupiah rallied at least 23 percent.
Since mid-October, net inflows have declined 75 percent to $1.4 billion from the previous six-month period. Local debt lost 9.4 percent in dollar terms in the final four months of last year, compared with a gain of 0.7 percent for dollar-denominated securities, according to JPMorgan indexes.
“The performance in the last few months has caused people to temper their enthusiasm for local markets,” said Gramercy’s Grills. Interest in the local bonds will pick up, “but we are not there yet,” he said.