Investors have poured $19.2 billion into local-currency emerging-market debt funds this year. That's the fastest pace of flows since 2010, helping to drive some of the biggest returns on record.
Some fundamental reasons exist for bond buyers to gravitate to this debt. For example, inflation is slowing in some of these countries, such as Brazil and Colombia. That means central bankers have room to cut interest rates, which typically bolsters bond markets.
But behind the broader rally and accelerating flood of cash into these markets lies something much more simple: a weaker dollar, which makes these emerging-market currencies look much stronger. The currency moves have fueled a good proportion of the 10.9 percent returns so far this year on the Bloomberg Barclays Global EM Local Currency Government Universal index. (Consider that a basket of emerging-market currencies has gained 9.6 percent so far this year against the dollar.)
In other words, this increasingly popular slice of bonds has essentially turned into a multibillion-dollar bet on the dollar. A stronger greenback could easily eat into returns and prompt these flows to reverse. After all, investors have plenty to be concerned about if they dig into the fundamentals of countries that account for a good proportion of local currency emerging-market indexes. And these bonds tend to be traded less frequently than those from developed markets, making them prone to greater volatility.
Consider debt of China, which accounts for 31 percent of the local emerging-market debt index. While the nation, the world's second-largest economy, is still growing steadily, it is doing so at the expense of an increasingly leveraged financial system. If the nation were to be downgraded, the effects would ripple throughout all of Asia, including places like Malaysia, which accounts for 3.3 percent of the debt in the index. India, meanwhile, which accounts for 18.4 percent of the index, has experienced rising inflation, putting pressure on its bonds. Its banks also face a ballooning mound of bad debt.
The point here is not to say these nations and their debt are a bad bet. There's just risk that hasn't materially gone away. And investors are getting compensated less to own it, with average yields falling to 4.7 percent from 4.9 percent in May, Bloomberg Barclays data show.
At the same time, emerging-market nations have been selling debt at a record pace as borrowing costs have declined. The amount of local currency emerging-market bonds has more than doubled in the past seven years to $4.4 trillion. This makes the countries more susceptible to difficulties should they be forced to refinance when borrowing conditions are less generous.
A lot of the money flowing into emerging-market bonds is simply chasing a rally in developing-market currencies. That can flip a lot more quickly than economic conditions. Investors may have wandered into a casino and not even realized it.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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