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Asian bonds provide a sweet spot in terms of high quality, risk adjusted yield in the fixed income universe in the face of a rising interest rate environment and a US dollar that is becoming stronger
Bayani S Cruz 11 Apr 2017
What would be the impact of a strong US dollar on your emerging market (EM) fixed income positions?
 
To be clear we have both US dollar denominated bonds issued by Asian companies but we also invest in local currency bonds.
 
As the US Federal Reserve attempts to normalize interest rates – this has been happening since the middle of 2013 – we’ve been grappling with when and how it will happen. Because of this, the markets have reflected very much ahead of time the valuations of the dollar versus emerging market currencies. And our sense is that a lot of the local currency bonds in Asia are underpriced.
 
To some extent we think there are some EM currencies which are undervalued from a long-term effective exchange rate basis.
 
On top of that, particularly for Asia, we are looking at a region where countries have persistent external surpluses.
 
All else being equal, the fundamental underpinnings continue to be constructive bearing in mind that interest rate differential is only one of several factors that affects the value of an exchange rate.
 
So while the value of the dollar has appreciated generally against EM currencies over the last 3-4 years, we think that right now we are seeing much more differentiation. And because it is underpriced we think that there are some attractive value propositions.
The Indian rupee and Indonesian rupiah, for instance, are two currencies that we view favourably in the context of the yield attractiveness.
 
 
How much yield differential do you expect for between the dollar and these currencies?
 
Essentially when we look in terms of the yield differential, we break it down in terms of what we refer to as the “currency carry”.
 
So if you look at the returns, the red line is the spot rate, so sometimes when we talk about total returns, even if the spot rate doesn’t appreciate, but if the yield or what we call the currency carry is attractive it could more than offset pockets of weakness.
 
So in the case of India the currency carry is a big part of the total return contribution. So spot rate is one thing, the currency carry advantage, as in the case of India and to a slightly lesser extent Indonesia, we view as very attractive from the perspective of diversification and getting better potential return.
By comparison, developed market yields in spite of the normalization of interest rates remain close to 0.0-0.1%.
 
Latin American bond opportunities are in Argentina, which has a huge currency carry (23.4%) and Brazil (13.0%). We are overweight in both countries. Russian bonds have been providing a lot of currency carry (10.0%).
 
               
Where are the recent fund flows to EM coming from?
 
In the last six months we’ve seen interest from long term investors, such as insurance companies and select pension entities looking and asking questions. Some are doing due diligence.
 
In Europe we are seeing interest in local currency bonds. They are much warmer to local currency opportunities in emerging markets than US-domiciled investors.
 

 

There’s always an Asian part component in their portfolios particularly for bonds issued by Asian companies. The technicals look very strong in Asia, but we don’t invest purely based on technicals. At the end of the day it’s all about fundamental investments. Investing in emerging markets is for the long haul. You consider short-term factors, but you want to anchor their posturing on a secular long-term horizon. 
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