Disappointing US dollar bond returns in EM local currency debt has led to a decline in flows into the asset class over the past decade. In this paper, we discuss the key reasons to invest in EM local currency debt, some of the factors behind the recent weakness in the asset class returns and prospects for the asset class going forward.

Key reasons to invest in EM local currency debt

The EM local currency debt market provides investors with an opportunity to gain exposure to those more economically advanced and stable emerging countries, such as Mexico and Poland. The development of local currency issuance is typically part of the process of a country moving along the credit spectrum. This development is due to factors such as the advancement of the domestic financial sector, which provides a natural buyer for local currency debt, and a strong track-record in US dollar-denominated debt issuance.

Those EM countries that issue local currency debt tend to have strong fundamentals. Many have low debt-to-GDP ratios relative to the developed world, which can provide some reassurance for those investors who are cautious of the higher volatility in EM. Increasing levels of stability can also be seen through the more common domestic disinflationary measures in many of the emerging economies, and investment in local currency bonds can be used to capitalise on these improvements.

The inclusion of EM local currency debt can diversify an investor’s portfolio in terms of economic and financial cycles, especially compared with many developed markets (DM). This is particularly useful in market conditions such as those we are likely to see in the near future, with the markets anticipating and pricing in expectations for a tightening in US monetary policy. In these periods, EM local currency bonds can provide some protection from the impact of movements in the rates market and decisions of the Federal Reserve (the Fed). Many of the emerging countries that issue local currency bonds have divergent interest rate cycles, which reflect their individual monetary and economic policies.

Finally, EM local currency debt is a relatively liquid asset class and this liquidity is expected to gain momentum, for reasons such as active debt management of governments, an increase in the number of market intermediaries, and deepening pools of local institutional demand. In a number of cases, governments have been steadily replacing external debt with local currency debt wherever possible to reduce their foreign exchange risk and exposure to sudden shifts in foreign investor sentiment.

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Depending on the strategy, risks may be associated with investing in fixed income, derivatives, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.