Prudential: Where's the Money? Emerging Market Local Debt.

(April 2, 2012) — Investors increasing their allocation to emerging markets should take a deeper look into debt issued in local currency, a paper from Prudential Fixed Income has said.

The paper says emerging market local debt offers investors an attractive combination of currency diversification, investment grade credit quality, and yield.

“The EM economy is a significant part of the global economy and this key position is emphasized by their contribution to world GDP, which is expected to approach 50% in 2012,” the paper says,

According to the paper’s author Cathy Hepworth, emerging market local market debt volume is expected to grow by at least 10% annually over the next decade as emerging market governments and corporations are increasingly switching to local currency financing. “The economic growth experienced by EM is no longer a cyclical phenomenon—it is more of a structural long-term trend,” she writes, adding that she expects more money to be allocated on a dedicated basis as the asset class becomes more mainstream over time.

Policy developments, structural reforms, and improved sovereign fundamentals have made investing in local market debt within emerging markets more attractive. “Since 2000, most emerging market countries have followed inflation-targeting regimes and managed floating currencies, which has improved transparency and provided the ability to anchor inflation expectations,” the paper concludes. Furthermore, lower, more stable inflation has allowed for the development of longer duration local bonds and has supported the attractive investment performance of the market. Meanwhile, emerging market countries have also reduced their public debt to about 40% of GDP, and according to Hepworth, that number will continue to decline.

A paper published late last year by AllianceBernstein also championed the growth of emerging markets, urging investors to look across equity, debt, and currency to manage the risks of the asset class. According to Morgan Harting, who manages the firm’s emerging market multiasset portfolio research, a portfolio with emerging stocks, bonds and currencies, managed in an active strategy, can capture a greater set of opportunities amid less volatility. Harting noted that corporate bonds in emerging markets have presented higher yields and better credit quality, as more and more bonds are being issued by emerging market companies — creating more of an active market. “That’s attractive to investors — pensions and insurance companies — who require more liquidity,” Harting told aiCIO.