TOP VIEW: The turmoil in emerging markets since the broad global sell off in mid-May has caused some to fear the three-year bull run in this sector is over. But emerging-market specialists believe many of these economies are strong enough to warrant investment in their domestic local-currency bond markets—a relatively new asset class that has evolved in line with the countries’ fiscal and monetary reforms. Investors must bear the local currency risk, but it may be worth it: These instruments are significantly outperforming dollar-denominated emerging-market debt.

Mexico is one example. In the decade following the peso crisis, Mexico tamed inflation and reduced domestic interest rates. This allowed it to extend its local currency yield curve; by the end of last year, it could issue debt with tenors out as far as 20 years. "Mexico has been a bit of a pioneer, but now more and more of these countries are trying to extend their yield curves," Peta says. Brazil is also.

Several factors are combining to improve the depth and liquidity of these local markets. Trading, clearance and settlement systems are being upgraded, while repo and derivatives markets are developing. Meanwhile, domestic institutional investors—insurance companies, pension funds and mutual funds—that need longer-dated local assets have emerged, providing another source of demand. "It’s an interesting dynamic, because we’re getting both the development of local bond markets from the issuer side and, at the same time, an expansion of the investor base, both offshore investors and local institutional investors," points out Rashique Rahman, head of emerging-markets fixed income strategy at HSBC in New York. "There doesn’t seem to be much sign of that turning around, despite the correction."

The Worm Has Turned
Professional investors refer to local currency-denominated emerging-market bonds as a new asset class in its own right because these investments have a completely different risk and return profile than equivalent dollar-denominated issues. Looking at Mexico again, 10-year local paper there, as Worth went to press, yielded around 9 percent, while the equivalent dollar-denominated debt yields were around 6.5 percent. Of course that means investors believe the former to be riskier than the latter. "You can think of the dollar bonds as pure country risk, and you can think of the local debt as country risk plus currency risk," Barrineau explains.

INTERNAL VS. EXTERNAL DEBT ISSUANCE
Country	2003 internal/total (%)	2004 internal/total (%)	2005 internal/total (%)	Total debt(US$bill)*
Argentina	8.2	8.2	9.1	77
Brazil	78.7	81.1	84.2	444
Colombia	65.7	69.8	73.5	49
Indonesia	100	98.1	96.1	51
Mexico	74.5	75.9	78.3	221
Peru	30	33.3	38.5	13
Philippines	58.5	56.8	54.3	57
Russia	20.8	32.8	35.5	62
South Africa	88.2	90.7	89.5	76
Turkey	84.8	85.9	86.1	218
TOTAL	69.4	72.2	75.5	1268
* As of June 30, 2005 Source: BIS

So those looking to local-currency bonds have to be happy bearing emerging-market currency risk. That type of bet did not look at all sound in May, when emerging-market currencies suffered. However, in the longer term, some professional investors believe this risk is worth taking. "I think it’s better to view the asset class right now less as a total return vehicle and more in relation to other fixed income asset classes," Barrineau argues. "In that context, it can still be an attractive investment, because you still have considerable spread over U.S. Treasuries." Barrineau believes the emerging-market currencies will not re-appreciate dramatically in the near term. "Export growth has slowed, and there is an atmosphere of general uncertainty in the market. But the well-run emerging-market countries, like Brazil and Mexico, I think, will stabilize at a lower level."

Clearly, the uncertainty over global growth prospects in the wake of G3 interest rate increases—the proximate cause of the broad sell off in May—and the fact that currency performance depends largely on governments adhering to sound policies, argues in favor of caution when evaluating these assets. Indeed, Teresa Kong, a senior portfolio manager with Barclays Global Investors in San Francisco, recommends that investors be much more selective when evaluating emerging-market credits. "I think we’ll see increased dispersion, where the market will start differentiating and assigning a higher risk premium to the countries that are going to suffer in a relatively more volatile environment," she says. "It’s probably a good time to reexamine what you have in your portfolio and, going forward with the backdrop of higher volatility and lower global liquidity, making sure you are long the right basket of securities."

One important indicator of issuing governments’ health is the status of their current account. Kong is wary of emerging-market countries that are running current account deficits, such as Turkey and Hungary. She is more optimistic about Latin American and Asian countries. Beddington agrees. "I think you avoid the current account deficits, and you look for current account surpluses," he says.

Those who wish to delegate this sort of analysis to specialist asset managers have a small but growing number of options. "In line with the development of the markets in general, we’re seeing EM local bond mutual funds that are global in nature being set up," says HSBC’s Rahman, although he notes that there are now only a handful of such funds.

John Ferry is a senior correspondent for Worth.

Art by Stephen Webster.

Additional Information
 Iceland on the Rocks