Are the Hard Times for Hard Currency Debt Over?

Rising US yields will drag on emerging market hard currency debt, but returns are still expected to outperform US corporate bonds.

(March 28, 2014) — Hewitt EnnisKnupp has told investors that now is a good time to build exposure to emerging market dollar-denominated debt in their growth portfolios.

Having suffered a dreadful 2013, emerging market debt that is denominated in a major external currency—known as hard currency—is experiencing a comeback.

In a white paper, the consultants said: “We believe that emerging market countries are on a stronger footing to cope with US monetary tightening than in the 1990s when US rate hikes triggered emerging market losses. The move to floating exchange rates, lower external debt levels, and higher currency reserves all provide greater resilience in the face of a crisis.”

In addition, despite rising US yields being expected to cause a drag on emerging market hard currency debt returns, Hewitt EnnisKnupp still expected positive returns of around 4% to 5% a year over the medium-term, making them far more attractive than US corporate bonds, for example.

Hard currency-denominated corporate bonds also outperformed sovereign bonds in the recent market sell-off, as they were supported by their lower sensitivity to interest rate moves and the global rally in credit spreads, the consultants continued.

But emerging market bonds issued in local currencies performed worse than hard currency bonds in 2013, as concerns over economic fundamentals led emerging market currencies to depreciate.

Many investors will feel concerned about how rising rates in the US could draw capital away from emerging economies. While Hewitt EnnisKnupp agreed that investment into emerging market bonds may well occur at a more cautious rate than in previous years, it argued that new investors would be attracted by emerging market bonds’ higher yields and solid strategic benefits once the current high levels of negative sentiment faded.

“We are further reassured by the fact that it has been retail investors that have been selling while institutional investors have remained invested,” it added. “We expect investor interest in emerging market bonds to resume in 2014 as the appeal of high yields at a reasonable reward for risk taken remains a driving market force.”

Having said this, investing in emerging market hard currency debt across the entire universe could result in some painful experiences. Countries with current account deficits are dependent on external financing, and as such emerging market hard currency sovereign bonds from these countries are consequently most vulnerable to rising US yields, Hewitt EnnisKnupp advised.

“These debtor countries with high inflation have been dubbed the ‘fragile five’, but there are other countries, such as those with high domestic credit levels that will also struggle with interest rate hikes.”

Therefore, the consultants recommended that investors interested in this space should only consider active managers. “There are good opportunities for managers to outperform emerging market debt benchmarks. This is particularly the case now. Emerging market bonds currently have a broad range of return prospects, driven by varying economic situations, policies, and sensitivities to factors such as interest rates and commodities.”

The full paper can be requested here.

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