U.S. dollars and Mexican pesos are counted and sorted at the end of the business day at a currency exchange in downtown Laredo, Texas, U.S. (Photographer: Eddie Seal/Bloomberg)

This Part of Emerging Debt Looks Good to Funds as Rates Rise

(Bloomberg) -- Interested in emerging-market debt but wary about rising bond yields as the Federal Reserve keeps raising interest rates? Then it might be worth looking at what used to be a riskier option -- local-currency bonds.

Historically low inflation rates in countries from Indonesia to Brazil mean, as a group, developing nations aren’t facing the pressure they sometimes had during U.S. monetary tightening cycles. And with the U.S. dollar depreciating even as the Fed hikes, local-currency debt has some insulation from worries such as supply hitting the Treasuries market.

This Part of Emerging Debt Looks Good to Funds as Rates Rise

“In a period of a weak dollar, EM local bonds will benefit from the improvement in the currency component,” said Manu George, Singapore-based senior investment director of Asian fixed income at Schroder Investment Management. “Returns from EM local bonds could outperform EM dollar bonds.”

Domestic notes sold by developing-nation governments have returned 1.9 percent so far this year, extending last year’s gain of more than 14 percent. Dollar securities from emerging markets, including corporate debt, are down 1.9 percent this year, according to a Bloomberg Barclays indexes.

The local debt could even be something of a refuge if trade tensions escalate, in the view of some. President Donald Trump’s protectionist moves have served in part to highlight the U.S. trade deficit and the increasing borrowing needs of the world’s No. 1 economy, with the fiscal gap widening.

Without Doubt

“I would take advantage of any weakness that generates to add to emerging-market FX risk,” said Edwin Gutierrez, London-based head of emerging-market sovereign debt at Aberdeen Standard Investments, referring to concerns of a potential trade war. He said he prefers “local currency without a doubt because of the weak dollar."

His favorites are Brazilian, Indian and Russian local-currency debt, as their rates remain high relative to inflation.

This Part of Emerging Debt Looks Good to Funds as Rates Rise

The Bloomberg Dollar Spot Index, which measures the performance of the dollar against 10 leading global currencies, has declined 3.1 percent so far this year after losing 8.5 percent in 2017.

The hard-currency notes from developing nations are likely to underperform because they remain “very correlated” to Treasuries, said Jean-Charles Sambor, the London-based head of emerging-market fixed income at BNP Paribas Asset Management.

‘Compelling Stories’

Fed officials, in the first interest rate decision under Chairman Jerome Powell, raised the benchmark lending rate a quarter-point on Wednesday and forecast a steeper path of hikes in 2019 and 2020, citing an improving economic outlook. The U.S. Treasury’s yield curve from 2 to 10 years steepened Wednesday.

While the potential for "massive" reductions in premiums on local-currency debt is now gone, after the big run-up in the securities, BNP Paribas’s Sambor said there are “still pretty compelling stories” in markets including India, Indonesia, Brazil and Peru.

Valuations especially for local-currency bonds are still attractive and the world is still quite far from a protracted trade war, Andre de Silva, global head of emerging-markets rates research at HSBC Holdings Plc in Hong Kong said in a Bloomberg TV interview.

Meantime, don’t count dollar bonds out completely. George at Schroder said "a rise in yields will make good quality EM dollar bonds attractive and we are likely to add exposure if yields show signs of stabilization.” He prefers corporate bonds for the yield pick-up, with examples including Petroleos Mexicanos and Petroleo Brasileiro SA.

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