Going Local in Emerging Market Debt: A Dozen Questions

In this paper, Alexander Kozhemiakin, Ph.D., CFA, Standish Director of Emerging Market Strategies, explores a profound shift that has taken place in emerging markets in recent years. Rather than issuing dollar-denominated debt, emerging market countries are increasingly doing such borrowing in their own local currencies. This emerging market local currency-denominated debt (EMLCD) is a relatively new asset class that has only recently begun to attract the attention of institutional investors. In a Q&A format, Alexander addresses some of the most commonly asked questions. Highlights include:

A decade ago, most emerging market sovereigns had little choice but to issue bonds denominated in dollars. Investors were leery of local currency instruments, whose value could be damaged by hyperinflation and high-profile currency crises. Broad reforms in fiscal, monetary and exchange-rate policies have enhanced emerging market creditworthiness, and fostered strong growth of the EMLCD market.
EMLCD and traditional emerging market dollar-denominated debt are two very different asset classes. The latter trades at a “spread” over U.S. Treasuries, while EMLCD is comparable to other global sovereign bonds, with their value driven by currency changes and duration.
Regional and/or country differences have a strong bearing on whether U.S.-denominated bonds or EMLCD predominates. Asia and Eastern Europe (ex Russia), for example, comprise 60% of EMLCD issuance; Latin America represents 46% of dollar-denominated issuances.
Emerging market exports are less dependent on commodities than is widely believed. Manufactured goods, for example, represent two thirds of the exports of EMLCD issuers.
EMLCD has held up relatively well during the financial crisis, in large part due to the economic reforms and progress made since the “Asian crisis” of 1998.
EMLCD is very liquid – trading at spreads generally tighter than U.S. investment grade debt – and well supported by local institutional investors.
From the perspective of U.S. investors, EMLCD tends to benefit from a weakening dollar.
High-yielding EMLCD is often used in “carry trades” – borrowing in low-yielding currencies and investing in high-yielding ones. But a number of EMLCD issuers are also favored for other reasons, such as their relative stability during periods of volatility.
EMLCD offers greater diversification benefits than emerging market equities, especially for portfolios that already have large equity allocations.
We have a positive view on EMLCD as an asset class that represents some of the higher-rated countries in the emerging markets universe, with the potential to benefit both from currency appreciation and relatively high local bond yields. From the demand side, we see support not only from local country institutions, but also growing acceptance from pension plans in Europe, Asia and the U.S.

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The preceding information is based upon the analysis of historical performance of various asset classes and assumptions with respect to future economic conditions. Past performance is not an indication of future results. This information is not intended to provide specific advice, recommendations or projected returns of any particular BNY Mellon Asset Management product.