Fixed Income Strategy
Timely discussion of fixed income market action and what it may mean for investors.
Peter Wilson, International Fixed Income Strategist
Emerging-Market Bonds—Dollar or Local Currency?
- An increase in local-currency borrowing by emerging-market countries has led to greater resilience in many economies.
- Changes in the debt structure also partly explain why performance of dollar-denominated sovereign bonds has been more consistent than that of local emerging-market bonds since 2009.
What it may mean for investors
- We continue to recommend an evenweight allocation to dollar-denominated emerging-market sovereign debt.
There are two main varieties of emerging-market (EM) sovereign bonds. There are local-currency-denominated bonds—sovereign debt issued in local currencies such as the Brazilian real, Mexican peso, or South African rand. The drivers of return (to a dollar-based investor) for this kind of debt are local interest rates and the exchange rate of the local currency against the U.S. dollar. The other type of EM bond is so-called “hard-currency” issuance—which effectively means sovereign debt issued in U.S. dollars. This functions much like any other credit instrument, with returns depending upon the level and movement of underlying U.S. Treasury yields, and on the credit spread of the EM bonds over the U.S. Treasury yield curve.
In Wells Fargo Investment Institute’s asset allocation program, the strategic benchmark for EM bonds is the latter category: sovereign bonds denominated in dollars, represented by the J.P. Morgan Emerging Market Bond Index—Global (EMBIG). But investors may hold local-currency-denominated bonds as an off-index allocation if circumstances are appropriate. In this week’s report, we assess performance of these types of EM debt and reiterate the reasons why our current recommendation is to maintain an evenweight allocation, 100-percent concentrated in dollar-denominated EM debt.
The Changing Structure of EM Debt
The changing structure of financial markets in major EM countries over the past two decades—including the relative importance of local currency versus dollar-denominated sovereign debt—has been of major importance in improving the resilience of these economies to external shocks. It also explains how these debt classes have performed in recent years and informs our recommendation on the asset class.
The memory of the great EM financial crisis of the late 1990s may be fading in investors’ minds, but some of the causes of the widespread contagion that took place can be traced to the debt structure. Investors’ appetite for local-currency risk was small in those days, as EM economies tended to be undiversified, commodity-dependent, and prone to political shocks. As a result, most sovereign funding was in the dollar-denominated market—that is to say, the borrower, rather than the investor, assumed the foreign-exchange risk of the transaction. If the dollar rose and the local EM currency depreciated, then debt costs rose as the sovereign had to convert more local currency (such as reals, pesos, or rand) to repay a given amount of dollar coupons or principals.
This obvious external vulnerability was known as the “original sin” of EM economies. In the late 1990s, this challenge was compounded by the fact that a large proportion of the debt was short-term (i.e. maturing within one year)—a fact which subjected many countries to high “rollover risk.” Consequently, economic and balance-of-payments crises, accompanied by local-currency depreciation against the dollar, soon morphed into debt crises and sovereign defaults.
Yet, by the early 2000s, as these economies recovered from crisis, lessons had been learned, and the new financial structures gradually become more resilient to external shocks. According to Gabriel Sterne of Oxford Economics, the average share of local-currency debt issuance in 14 large EM countries rose from 15 percent to 60 percent between 2004 and 2012. This development dramatically lessened these economies’ vulnerability to foreign-exchange risk.1
How Financial Market Structure Explains Performance
This new resilience in financial markets—along with greater economic diversification and receding political risk—was a major reason why the emerging markets weathered the great 2008-2009 financial crisis in developed economies as well as they did. If we look at performance of both types of EM debt over the period, we can draw some interesting conclusions (Chart 1). When we review a slightly longer period, 2004-2017 (through May 31) we find that dollar-denominated EM bonds were the best performers among the 13 major fixed-income classes that we follow, with cumulative returns of 178 percent. Local-currency-denominated bonds came in at number three, with cumulative returns of 122 percent (U.S. high-yield debt took the number two slot.) This is as we might expect, since these are among the “riskiest” debt classes (in terms of price-movement volatility)—so as asset allocation theory would predict—over time, they should have seen the highest returns.
As Chart 1 illustrates for the period between January 2009 and May 2017, the picture is slightly more mixed. U.S.-dollar-denominated EM sovereigns were the third best performer, returning a cumulative 116 percent. Yet, local-currency-denominated bonds were only eighth (out of 13) and cumulative returns of 40 percent over eight-and-a-half years were only in line with the Bloomberg Barclays U.S. Aggregate index.
The outperformance of the U.S.-dollar-denominated EM sovereign-debt sector over this period can be explained in part by the greater variability in local-currency EM bond returns (than returns of U.S.-dollar-denominated EM debt). This, in turn, was a function of foreign-exchange risk. Typically, in this period, we find local-currency bond returns were either near the top or near the bottom of the league relative to annual fixed-income class returns. In 2011 and in 2013-2015, local-currency bonds were obvious underperformers. In 2009-2010, in 2016 and so far this year, they have been leading the way.
That this inconsistency of returns has to do with foreign-exchange risks can be seen by the close relationship between EM currency indices and commodity prices. Between the peak in 2011 and the trough in early 2016, the Bloomberg Commodities index fell by almost 60 percent and the J.P. Morgan Emerging Market Currency Index (EMCI) was 42 percent lower. Since that trough, both indices have stabilized and are moving in broad trading ranges. The losses or low returns experienced by the local-currency EM debt class in this period had to do with the declines in local currencies against the U.S. dollar. This was either directly, because of the direct currency loss to the dollar-based investor, or indirectly, as fragile currencies prevented interest rates from falling and thus caused weakness in local-bond prices. Since 2016, policy interest rates in many EM countries have been able to fall as currencies have stabilized and inflation has been benign. Thus, high starting yields—and capital gains from rising bond prices—have been the drivers of the higher returns in these periods. Additionally, they were the fruits of currency stabilization.
As for U.S.-dollar-denominated EM sovereign bonds, the absence of foreign-exchange gains or losses has meant less extreme, but still very healthy, returns over the period, as the quilt chart shows (Chart 1). We note that, in poor years for local-currency bond returns, dollar-denominated bonds tend to outperform—and in some cases, returns can strongly decouple from the poor performance. In the best years for local-currency bonds, even if U.S.-dollar-denominated bonds do not outperform, they still share a large part of the performance. This is simply because, when the macro and currency backdrop to the sector is favorable, dollar bonds also will tend to benefit from high starting yields and credit-spread tightening.
A global environment of recovering growth and modest inflation currently provides something of a fair breeze, if not a strong following wind, for all EM assets. In our fixed-income strategy, we recommend that investors hold an evenweight tactical allocation to EM bonds, and that this allocation should be in dollar sovereigns rather than in local-currency issues. Our rationale is four-fold.
First, as stated above, our strategic benchmark is the dollar-denominated EMBIG. This means that, for an off-index allocation to local-currency debt, we face a higher conviction hurdle than we would if the strategic index were in local currency, or in a blend of both types of debt. Second, while we are not particularly negative on EM foreign-exchange rates in 2017, economic and political risks remain in several key economies—and in any case, we remain broadly positive on the U.S. dollar as the Federal Reserve continues to raise rates. Third, as the performance record shows, (over time), we see that dollar-denominated debt often outperforms in down years and captures much of the upside of local debt in the better years.
Finally, we believe that investors are starting to appreciate that the default risk of dollar-denominated sovereigns is potentially lower than it has been historically. This is another implication of the change in debt structure we mention above. When most of the borrowing was denominated in dollars, in times of sovereign stress, default, restructuring and investor haircuts were the main routes to reducing government indebtedness and restoring solvency. Now that most EM financing is in local-currency-denominated markets, and the percentage of foreign debt is small, for governments facing stress, currency depreciation and inflation will be the main route of macroeconomic adjustment.
The above discussion and rationale form the background to our current advice on EM bonds, which is summarized in our latest Asset Allocation Strategy Report as follows: “Higher yields and spreads in U.S.-dollar-denominated sectors may offer the potential for more stable returns, but local-currency bonds are expected to be more volatile. We recommend a 100 percent dollar-denominated strategy.”
1 FT.com, (Financial Times), “EM sovereigns: Buy defaultlessness”, January 6, 2017.
Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Because bond prices generally fall as interest rates rise, the current low interest rate environment can increase the bond’s interest rate risk. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater price volatility. These risks are heightened in emerging markets.
In addition to the risks associated with investing in international and emerging markets, sovereign debt involves the risk that the issuing entity may not be able or willing to repay principal and/or interest when due in accordance with the terms of the debt agreement.
U.S. Aggregate Fixed Income: Bloomberg Barclays US Aggregate Bond Index is an index composed of the Government Bond Index, the Asset-Backed Securities Index and the Mortgage-Backed Securities Index and includes U.S. Treasury issues, agency issues, corporate bond issues and mortgage-backed issues.
U.S. Corporate Fixed Income: Bloomberg Barclays US Corp Investment Grade Index includes publicly issued U.S. corporate and Yankee debentures and secured notes that meet specified maturity, liquidity, and quality requirements.
High Yield Fixed Income (U.S. HY): Bloomberg Barclays U.S. Corporate High-Yield Bond Index covers the U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB= or below. Included issues must have at least one year until final maturity.
Emerging Market Fixed Income (EM Bond): JPMorgan EMBI Global Index is a U.S. dollar-denominated, investible, market cap-weighted index representing a broad universe of emerging market sovereign and quasi-sovereign debt. While products in the asset class have become more diverse, focusing on both local currency and corporate issuance, there is currently no widely accepted aggregate index reflecting the broader opportunity set available, although the asset class is evolving. By using the same index provider as the one used in the developed-market bonds asset class, there is consistent categorization of countries among developed international bonds (ex. U.S.) and emerging market bonds.
Emerging Market Fixed Income (EM Bond (LC)): J.P. Morgan Government Bond Index-Emerging Markets Global (USD Unhedged) is a comprehensive global local emerging markets index, and consists of regularly traded, liquid fixed-rate, domestic currency government bonds.
Preferred Stock (Preferred): S&P Preferred Stock Index: The S&P U.S. Preferred Stock Index is designed to serve the investment community's need for an investable benchmark representing the U.S. preferred stock market. Preferred stocks are a class of capital stock that pays dividends at a specified rate and has a preference over common stock in the payment of dividends and the liquidation of assets.
Municipal Bonds (U.S. Municipal): Bloomberg Barclays Municipal Index represents municipal bonds with a minimum credit rating of at least Baa, an outstanding par value of at least $3 million and a remaining maturity of at least one year. The index excludes taxable municipal bonds, bonds with floating rates, derivatives and certificates of participation.
Developed Market Ex-U.S. Hedged Fixed Income DM Bond (Hedged)): JPMorgan Global Ex United States Index (JPM GBI Global Ex-US) is an unmanaged market index representative of the total return performance, on a hedged basis, of major non-U.S. bond markets. It is calculated in U.S. dollars.
Developed Market Ex-U.S. Unhedged Fixed Income (DM Bond (Unhedged)): J.P. Morgan GBI Global ex-US Index (Unhedged) in USD is an unmanaged index market representative of the total return performance in U.S. dollars on an unhedged basis of major non-U.S. bond markets.
U.S. Mortgage Backed Securities (US MBS): Bloomberg Barclays US Mortgage Backed Securities (MBS) Index includes agency mortgage backed pass-through securities (both fixed-rate and hybrid ARM) guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).
U.S. Agency: Bloomberg Barclays US Agency Index measures the performance of the agency sector of the U.S. government bond market and is comprised of investment grade native-currency U.S. dollar-denominated debentures issued by government and government-related agencies, including FNMA.
U.S. TIPS: Bloomberg Barclays US TIPS Index represents Inflation-Protection securities issued by the U.S. Treasury.
U.S. Treasury: Bloomberg Barclays US Treasury Index includes public obligations of the U.S. Treasury with a remaining maturity of one year or more.
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The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.
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