Local currency corporate debt, the new kid on the EM block

Jonathan Boyd
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Local currency corporate debt, the new kid on the EM block

There are four main benefits to investing in EM local currency: exposure to shorter duration, higher yields, higher credit quality and what we view as attractive valuations.

The currency valuation argument is particularly compelling. Based on our internal analysis, we believe roughly 75% of EM currencies are undervalued, having weakened significantly over the last few years.

It’s always difficult pinning a valuation argument on currencies but, if a currency is fundamentally undervalued, over the medium term we have seen that it tends to normalise.

Yield versus duration

If the Fed tightens rates more aggressively than the market expects, it doesn’t favour duration, so investors may be looking for shorter-duration products. This asset class is the shortest duration (c.3 years), and highest yielding (~9%) product in the fixed income space. In comparison, most EM and DM fixed income duration products are between 5-10 years with yields of between 5-6%.But it doesn’t mean you’re aggressively sliding down the credit curve to get the yield; around 75% of the EM local currency corporate debt market is investment grade rated with an average rating of BBB.

Therefore, in an environment where duration is selling off aggressively, this asset class offers a yield buffer while there is also the potential for undervalued EM currencies to rally.

Growth in offshore issuance

The natural progression of this market has resulted in an increase in offshore local currency debt issuance. This is the area of the market we’re most excited about and where we see the most potential for growth in the medium term.

We saw a number of firsts last year; the opening of the offshore Indian (Masala) corporate bond market, and corporates issuing in offshore pesos in Argentina following the country’s return to capital debt markets in the hard currency space. In addition, we are also seeing a return to market of companies issuing in Russian roubles, Argentine pesos, Czech korunas and Turkish liras which we believe is a further positive move for this market.

This year, we expect to see the reopening of the Brazilian real market, particularly given the positive political and structural changes we’ve witnessed there.

In our view, the recent opening of a new local currency corporate debt market in Peru creates a benchmark for other term borrowing in local currency corporate bonds in the country and we expect further supply following the success of this bond. We believe this is another positive development in the market as it further diversifies the universe. This also continues the growing momentum of local corporate issuance in a Euroclearable format.

Alpha opportunities

At the sector level we currently like corporates in the commodity-related space; we think the oil price is going to be supportive as we believe we’re moving into a more balanced supply-demand dynamic within the oil market on the back of the OPEC/non-OPEC agreement late last year.
In our opinion, this asset class should resonate with investors already comfortable with EM local currency sovereign exposure. The local currency corporate segment of the market is a lower beta, higher yielding and lower duration alternative and adding an allocation into this sub-asset class can provide investors with a holistic approach to EM local currency fixed income exposure.

 

Brent David is a portfolio manager at BlueBay Asset Management