Local currency debt a new focus for emerging market investors

Institutional investors are making big moves into emerging markets local currency debt strategies, taking broad strides to catch up to allocations previously made to emerging markets bonds denominated in U.S. dollars.

And sources say the trend has just begun, with more pension plans and sovereign wealth funds expected to tap the asset class for better risk-adjusted returns, diversification and exposure to fast-growing economies and currencies.

The asset class has seen explosive growth in the U.S. in the last two years, as pension funds expand into stand-alone local currency mandates or hire money management firms that blend a mix of hard- and local-currency bonds in one portfolio.

• The $48.1 billion Massachusetts Pension Reserves Investment Management board, Boston, carved out $900 million in August for local currency debt;

  
  



• The $4.4 billion Missouri Local Government Employees Retirement System, Jefferson City, hired Stone Harbor Investment Partners last year to run $180 million in emerging markets blended debt;

  
  



• The $21,44 billion Iowa Public Employees' Retirement System, Des Moines, began a search in January for an emerging markets debt manager to run $350 million in a blended strategy, according to an RFP on its website; and

  
  



• The $211 million Brookline (Mass.) Contributory Retirement System started a search in August for an emerging markets local currency debt manager to run $4 million initially.

  
  

According to InterSec Research LLC, a research and analytics firm, new institutional mandates for emerging markets local currency debt in 2010 shot to $1 billion, up from $115 million of new mandates in 2009. As of June 30, the latest available data show that U.S. institutional investors were on track to double 2010's level.

Investment consultant NEPC LLC, Cambridge, Mass., conducted 65 emerging markets local currency debt searches with a combined asset value of more than $2 billion in 2011. That's up from next to none in previous years.

At Mercer, search activity in the U.S. cooled in 2011 after booming a year earlier. From a base of just two searches each in emerging markets debt and local currency debt in 2008, local currency searches shot to 29 in 2010 then fell in 2011 to 15 as overall search activity subsided. Emerging markets debt searches rose to 16 in 2010 before dropping to seven in 2011.

While 2009 saw a pretty dramatic spike in new emerging markets debt allocations by U.S. institutional investors, “it was still mainly your opportunistic emerging markets debt strategies, and they were still primarily U.S. dollar-based,” said Brendan Cooper, head of analytics at InterSec, Stamford, Conn. “We're seeing a shift more into just pure local currency products being funded.”

But Thomas Brock, CEO of Stone Harbor in New York, said: “The phenomenon is global. We're seeing the trend of increasing interest from official institutions around the world, including from sovereign wealth funds, and those mandates can be quite large.”

Big winners include Stone Harbor, Wellington Management Co. LLP, Pacific Investment Management Co. LLC and Pictet Asset Management Ltd.

Additionally in the U.S., old favorites in hard-currency strategies — Ashmore Investment Management Ltd. and Standish Mellon Asset Management Co. LLC — are also winners in local currency, as are some firms with emerging markets equity expertise, such as Grantham, Mayo, Van Otterloo & Co LLC, Mondrian Investment Partners Ltd. and Investec Asset Management.

Wellington's prodigious pipeline caused the firm to close its emerging markets local currency debt strategy in late 2010, when assets were about $3.5 billion, said a source familiar with Wellington who asked not to be named. By year-end 2011, assets in the strategy topped $9 billion — nearly a threefold increase. Wellington spokeswoman Sara Lou Sherman declined to comment.

According to eVestment Alliance, Marietta, Ga., Stone Harbor's assets in the strategy more than doubled in 2011 to $12.2 billion from $6 billion, while PIMCO's rose 46.8% to $18.6 billion.

Local currency strategies began a “once-in-a-lifetime” phase as they became “discovered” in the U.S. about 18 months ago, said Alexander Kozhemiakin, managing director and head of emerging markets debt at Standish Mellon, Boston.

“It's spreading like wildfire right now,” he said. “We're invited to finals once every other week now. ... We're going through a who's who of corporate plans in the U.S.” He declined to identify the plans.

Experts say Pictet has been a perennial contender for new business in emerging markets local currency bonds in the U.S. But globally, its emerging markets local currency assets fell to $8.8 billion in 2011 from $9.1 billion, a 3.3% drop.

Simon Lue-Fong, director and head of emerging markets fixed income at Pictet, said “rotations of our client base” did cause a loss in local currency assets. Wholesale clients, after having gotten into the asset class early, took profits in 2011. Mr. Lue-Fong said that trend would be reversed by inflows from pension funds. He described the U.S. market as a “big, sleepy giant” that is being roused by emerging markets local currency debt.

MassPRIM reduced its global equity allocation by six percentage points to 43% in August; some of that was used to fund a 2% allocation to emerging markets local currency debt. That complements a $700 million allocation to hard currency in place since 2004.

“We think we can get a better risk-adjusted return and lower overall portfolio risk” by moving from equities to local currency emerging markets bonds, said Stanley P. Mavromates, MassPRIM's chief investment officer.

MassPRIM is expected to hire Pictet to run $400 million and Investec and Stone Harbor to run $250 million each at a Feb. 7 meeting.

Not all of the moves are being funded by equities. Indeed, a major driver comes from the breakdown of the core-plus approach to structuring a bond portfolio. Whereas higher-risk, higher-returning asset classes such as high yield and emerging markets debt were once part of core-plus, they're now getting their own time in the spotlight (Pensions & Investments, Oct. 3).

“Five years ago when I talked to U.S. investors about emerging markets local currency bonds, very few people were willing to listen,” Standish Mellon's Mr. Kozhemiakin said. “Up until recently, U.S. investors have been wedded to the idea of core-plus as an investment paradigm” and had home and equity biases.

Why not just invest in emerging markets equity? “The answer is that, at the very least, you get better risk-adjusted returns, if not better risk-adjusted returns,” by investing in local currency debt instead of emerging markets equities, Mr. Kozhemiakin said.

But not all investors go for local currency mandates. “We like the diversification between local currency and external (or hard-currency) debt,” said Moustapha Abounadi, director, investment research in fixed income at Rogerscasey Inc., Darien, Conn. In 2011, it was easily to see how the two “can diverge quite substantially ... (like) in the third quarter, when the sell-off in emerging markets currencies was quite massive.”

Brian Collett, CIO of the Missouri Local pension fund, said during the manager search process, Stone Harbor executives convinced him they could add value through allocating among hard currency sovereign, local currency sovereign and local currency corporate debt.