Emerging Markets: Catch the Yield Where You Can

logo-cropped-11Large U.S. corporates are diversifying by issuing in foreign markets and currencies

Source: The Wall Street Journal

Not to worry, there are a few more corners of yield left in the world of bonds.

The latest target: emerging-market bonds in local currencies. After pulling out cash for the past three years and into the first quarter of this year, long-term investors including pension funds, endowments and foundations around the world started allocating money toward the asset class, according to institutional investment data provider eVestment.

The shift into local-currency bonds represents a new leg along the risk continuum. Much of the rush into emerging-markets bonds had been led by flows into bonds denominated in U.S. dollars. That protects the investor from currency fluctuations. But the spreads investors demand over U.S. Treasurys for these bonds are looking expensive. And so yield chasing in local-currency bonds took off post-Brexit and has pushed spreads to their lowest in a year—though still far from historical lows.

The attraction are real yields that remain far higher than those in other bond markets. Take Indonesian government bonds, which have received almost $9 billion of flows this year. Inflation is relatively low, monetary easing continues and a 10-year bond currently yields just over 7%.

Key to the trade has been relative quiescence in currency volatility. A surging dollar against emerging-markets currencies can wipe out whatever yield might be available. But since the end of June, for instance, the Indonesian rupiah is flat, and down only 4% for the year compared with its 20% loss in 2013. Any losses on the currency are made up by yield, if an investor doesn’t hedge.

Meanwhile, the cost of hedging the currency risk is also falling. That is a side effect of the rise in the London interbank offered rate, which has shrunk the difference between dollar and emerging-market interest rates. For instance, the spread between Libor and its Indonesian counterpart, the Jakarta interbank offered rate or Jibor, has shrunk to close to 6 percentage points from 8 earlier in the year.

The risk is that the current sense of calm is upended. In addition to currency risk, liquidity for these bonds can dry up quickly and capital controls are often in play. For now, those concerns have been pushed aside. A measure of risk appetite for emerging-market currencies, tracked by J.P. Morgan, is near its highest since 2013. That was also when cumulative flows into local bond markets peaked last time around, followed by record outflows. Emerging-market currency volatility, a key consideration, is at its lowest this year.

Emerging markets, sensitive to the dollar and U.S. rates, seem to have more easily digested expectations of the next Federal Reserve rate increase this time around. That may encourage even more flows to local currency bonds. For now, investors are grabbing the yield while it’s still there.