China's currency devaluation might extend the current two-year stay in the penalty box for local currency bonds, the biggest segment of the emerging markets debt opportunity set, but growing interest in unconstrained fixed-income strategies could leave portfolio managers better positioned to buy them again when the current headwinds subside.
For emerging market debt, the past four or five years have been a two-part story, said Ashley Perrott, a managing director and head of pan-Asia fixed income with UBS Global Asset Management in Singapore.
The first part saw very strong demand for local currency bonds and solid demand for hard currency bonds as quantitative easing in the U.S. and a European banking crisis drew investors to the higher yields and stronger fundamentals offered by China and its Asian neighbors, he said.
But the taper tantrum of May 2013 — when the Federal Reserve's then-Chairman Ben Bernanke signaled the party would eventually come to an end — brought an abrupt reversal, with local currency bonds suffering the heaviest outflows, he said.
The dollar's gains in the past two years have robbed local currency bonds of a central selling point: that in addition to offering higher yields than hard currency bonds, investors could hope to pick up additional gains from the long-term appreciation of Asian currencies.
The years since the taper have been tough ones on the whole for emerging market debt, with local currency bonds bearing the brunt of outflows, simply out of concern with how local currencies would react, said Prashant Singh, Singapore-based managing director and lead portfolio manager (Asia) — emerging markets debt with Neuberger Berman Investment Management.
Still, interest in the broader asset class hasn't collapsed, said Mr. Singh. Instead, it has skewed to hard currency bonds denominated in developed market currencies such as the dollar, he said.
According to data from New York-based fixed-income boutique Stone Harbor Investment Partners, the local currency sovereign bond segment of the emerging markets debt opportunity set comes to $1.5 trillion, more than the hard currency sovereign bond segment, at $676 billion, and the corporate debt segment, at $809 billion, combined.
China's Aug. 11 devaluation, meanwhile, threatens to leave local currency bonds even more out of favor, as the country's importance as an export destination for other emerging markets would see declines in the renminbi dragging down the currencies of China's many trading partners, noted Mr. Singh.
How much that dynamic comes into play “depends very much on the extent” of the renminbi's devaluation, and the consequent declines in currencies such as the Malaysian ringgit, the Korean won and the Taiwanese or Singapore dollars, said Robert Stewart, Hong Kong-based head of global fixed-income strategies with J.P. Morgan Asset Management.
Market veterans say it's too early to predict a reversal of fortunes that would focus interest again on local currency bonds.
“We're not quite at the stage of "the sky is always darkest just before dawn,'” as a number of headwinds remain, said Mark Evans, a London-based investment analyst, emerging market debt and currency, with Investec Asset Management.
It's “too early to call the end of this,” agreed J.P. Morgan's Mr. Stewart, noting a number of themes — including China's slowing growth and the dollar's strengthening — have yet to fully play out. Local currency bonds could remain out of favor for a few more years, he said.
Even so, Paul Timlin, Stone Harbor's London-based head of global sales, said interest in local currency debt, and emerging market debt broadly, remains significant. In light of current headwinds, however, some investors with local currency allocations and others contemplating initial allocations are focusing more on unconstrained, or blended, strategies that allow portfolio managers to decide which segment of the market to favor at any given time.
“For asset owners, we have preferred active strategies in EMD, and especially "blended' or "open mandate' strategies” — which allow the manager to make the choice between hard and local currency, and specific foreign exchange exposures — for some time,” said Aaron Costello, a Singapore-based managing director and investment consultant with Cambridge Associates.
Those blended strategies should allow managers to add value and generate decent returns over what will be a tough few years for the asset class in general, he said.
Mr. Singh said his team, which joined Neuberger Berman from ING Asset Management two years ago, has seen a clear pickup in interest in blended strategies, which accounted for two-thirds of the firm's $5 billion EMD book of business as of June 30. The blended strategy, started in September, 2013, saw its assets under management jump to $3.3 billion as of June 30.
Other firms have noticed the same trend. Mr. Stewart said J.P. Morgan added another blended EMD strategy to its lineup two months ago, with $150 million under management now.
Ward Brown, a Boston-based portfolio manager with the emerging markets debt team at MFS Investment Management, said his firm has a hard currency EMD strategy with $10 billion under management, and a local currency strategy with $400 million, but MFS is working on launching a blended strategy targeted to the institutional marketplace.
