Emerging market local currency debt (page 2 of 2)

Of course a mandate could alternatively allow some discretion to take advantage of such strong trends, within limits.

What this means for the overall risk profile of a well-managed local currency debt portfolio is that uncorrelated gains across a diverse group of countries can occasionally be boosted for a period of time through exposure to an underlying G3 trend of which the manager is particularly confident. Where he is not so confident he can hedge such risk away. So the risk profile is more asymmetric, with less downside risk than for dollar debt.

There will remain some sceptics. What about sudden devaluations? What about the leverage implicit in derivative instruments? A sudden devaluation is rarely an altogether unforeseen event, not least as the macro-economic factors that eventually lead to such drastic policy action builds up over a period of time and can be foreseen.

Also, there is a significant difference between investing in a spot exchange rate and a yielding debt or non-deliverable forward in which the risk of devaluation is compensated for. Concerning leverage, it is fairly straightforward to account for the full economic exposure of a derivative transaction (as opposed to the cash deposit on the contract) and treat any excess as leverage, to be strictly controlled by mandate restrictions - possibly to zero.

There are two competing philosophies of how local currency debt should be managed. Some treat it like a high-yielding money market, with a focus on reducing risk through moving up the credit spectrum in a relatively static context. The alternative, consistent with Ashmore's approach, is to view country risk as the key to value creation through an active top-down macro strategy.

During the mid-1990s when there were more fixed exchange rates, the former strategy appeared to do well, but in a world of floating exchange rates, the scope for adding value through a strong focus on macro management has increased just as the risk of sudden maxi-devaluations has likewise decreased.

Finally, under what circumstances should local currency debt be preferred to dollar debt? There are three main classes of institutional investors that have invested.

First are those that already have some dollar debt and want a separate local currency debt mandate to add further diversification. Second are those that are more conservative, often coming from fixed income perspective, and who are attracted to the better correlations, credit ratings and shorter duration. Third are those who wish to use local currency debt tactically within a dollar debt mandate.