Emerging market local currency debt

The increasing interest in emerging market debt from pension funds, other institutional investors and private investors, attracted by high returns and strong diversification has largely concentrated on dollar-denominated debt instruments.

However, local currency denominated debt and related instruments should not be overlooked, even in the context of an initial emerging debt investment. Despite exposure to currency movements, local currency debt provides a lower risk - albeit slightly lower return - alternative to the dollar debt.

By way of illustration, over the last five years to end June 03 (which includes the Russian crisis in 1998) Ashmore's Local Currency Debt Portfolio (LCD) returned 17.38% annualised net of fees, compared to 18.80% for Ashmore's flagship dollar-denominated debt fund, the Emerging Markets Liquid Investment Portfolio (EMLIP); and over the last three years LCD has returned 18.04% per annum compared to 23.05% for EMLIP.

Over the last three years the annualised standard deviation of monthly returns has been 6.32% for LCD compared to 10.79% for EMLIP. Hence LCD's volatility is actually less than that for the JP Morgan Global Government Bond Index (at 7.02%) and not much more than the JP Morgan US Government Bond Index (5.26%).

The emerging market local currency debt universe consists of local currency denominated debt instruments such as local Treasury bills, but also other currency and interest rate exposures through derivative instruments such as currency non-deliverable forwards and interest rate swaps.

Whilst on the face of it the added currency risk and the use of derivatives may flag additional risk, the reality is rather different. Sovereign risk, currency risk, and interest rate risk are all highly correlated in many emerging countries (most of the time) and hence by gaining exposure to currency and interest rate risk one is still primarily taking one decision: a decision about the macro risk, just as one does with dollar-denominated debt.

Also, whereas dollar-denominated debt has an average duration of 4 to 5 years, a local currency portfolio may typically have an average duration of 12-18 months, with an interest rate duration of as little as 6 weeks.

The underlying credits may also be of better average quality: containing only sovereign risk and including many of the investment grade credits (in Central Europe and Asia) which would not typically be attractive in a dollar EM debt portfolio due to the narrow spreads above US Treasuries on the same investment grade sovereigns' dollar-denominated bonds.

Also, the investor base is different to that of dollar-denominated debt, in particular giving an even more negative correlation to global fixed income indices than available for dollar-denominated emerging debt.

The monthly correlation of LCD to the Lehman Aggregate over the last five years to end June 2003 was at -0.24 even more negative than the -0.18 for EMLIP.

There is scant correlation between the different countries' local markets except in two clusters: Central Europe and SE Asia, where similar external factors can be dominant. In part this is due to local institutions being major market participants.

There are, of course, some factors that may impact the whole local currency debt market. The major risks however all fall under the category of developed market events, most notably G3 interest rate and foreign exchange moves. But such risks can be hedged.

For example, if one is worried about movement on the Dollar/Euro one can as either a Dollar- or Euro-based investor hedge such risk out. 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.