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An Alternative Approach To Accessing EM Local Debt

3 May 2018

GAM Investments' Michael Biggs believes that while some investors have been reluctant to allocate to emerging market (EM) local currency debt, many of the inherent risks can be hedged by diversifying funding currencies while potentially enhancing risk-return characteristics.

Understanding volatility

EM local currency debt has performed well over the past two years and should continue to benefit from high yields, improving domestic fundamentals and rising global growth. Yet the size and frequency of drawdowns of this asset class have made some investors reluctant to make a structural allocation in recent years.

While these fears appear justified at first glance – the asset class has exhibited equity-like volatility while providing bond-like returns – we believe these return characteristics can be improved by diversifying the funding currencies used.

The asset class does suffer frequent downturns, and the level of returns does not appear to compensate for the volatility (Table 1). The GBI-EM local currency bond index has suffered negative returns in five of the past 14 years at an average drawdown was 7.3%.

However in our view 1) the volatility of local currency EM debt is driven largely by movements in the USD, rather than weakness in EM FX and 2) it can be reduced significantly and cheaply by using other low-yielding DM currencies to hedge the USD risk.

EM local debt - Chart 1

Source: JP Morgan EMBI Monitor December 2017, GAM.

Past performance is not an indicator of future performance and current or future trends.


The idea

The volatility of EM local currency debt stems mainly from the FX component. The FX risk can be hedged directly, but this is typically costly and inefficient as the carry on EM currencies tends to be high.

However, shocks to EM FX in aggregate tend to be driven by global macroeconomic developments, including changes in the USD. These shocks affect other DM currencies as well, with the result that EM and DM FX moves are closely correlated (Chart 1).

These DM currencies tend to have very low yields and, if they are used as funding currencies, provide a cheap and efficient hedge to the FX risks inherent in local currency EM debt.

Chart 1: EM and DM FX

EM local debt - Chart 2

Source: Bloomberg.

Past performance is not an indicator of future performance and current or future trends.


EM local currency debt funded in CAD

To illustrate this idea, we use the Canadian dollar as our funding currency. It is well suited to this exercise as: 1) it is a low yielder, and; 2) like EM FX, it is also exposed to moves in commodity prices. The correlation between CAD and the JP Morgan GBI-EM Global Diversified is shown in Chart 2.

Chart 2: CAD and JP Morgan GBI-EM GD

EM local debt - Chart 3

Source: Bloomberg.

Past performance is not an indicator of future performance and current or future trends.


By investing in EM local currency debt and financing the investment in CAD, one is effectively putting on two trades: a) long EM FX versus the US dollar and; b) long the US dollar versus the Canadian dollar. The USD risk is effectively removed and is replaced by CAD risk. If EM FX and CAD are closely correlated, however, the overall volatility of the trade is reduced.

Chart 3: CAD funding reduces volatility

EM local debt - Chart 4

Source: Bloomberg.

Past performance is not an indicator of future performance and current or future trends.


The data supports this view. Chart 3 compares the USD returns of the GBI-EM funded in USD and CAD. (We index the return series to 100 on 31 December 2003 so that our sample is the same as that shown in Table 1). The returns are clearly far more stable when funded out of CAD than when funded out of USD.

In our view what concerns investors most is not volatility per se, but the frequency and magnitude of drawdowns. The annual returns to the USD and CAD financed investments in GBI-EM are shown in the chart 4.

Chart 4: Annual returns

EM local debt - Chart 5

Source: Bloomberg.

Past performance is not an indicator of future performance and current or future trends.


Since 2004, the GBI-EM financed in USD has suffered drawdowns on five occasions, with an average annual drawdown of 7.3%. The GBI-EM financed in CAD, in contrast, has suffered two drawdowns, with an average drawdown of 1.9%.

Conclusions and risks

Our analysis suggests that the US dollar risks inherent in EM local currency debt can be hedged cheaply by diversifying funding currencies and, in doing so, the frequency and magnitude of drawdowns is reduced significantly.

This hedge would naturally be less effective in reducing volatility if the Canadian dollar suffered shocks that were specific to it and did not affect EM FX. Global factors that boost the Canadian dollar should in general boost EM FX as well, so the shock would probably have to be domestic. If domestic factors cause the Canadian dollar to weaken, then the hedge would no longer lower volatility but investor returns would increase. If domestic factors caused the CAD to strengthen, in contrast, returns would fall and volatility would increase. We would view sustained CAD strength due to domestic factors as unlikely, but even this risk could be minimised by using a range of funding currencies such as the Norwegian krone, Australian dollar or euro as well as the Canadian dollar.

Unrecognised hedging solution

We believe the ability to reduce the risks to EM local currency debt is insufficiently recognised in the market. Asset allocators who look at the return characteristics of the asset class based on USD-funded indices tend to under-allocate to EM local currency debt and are potentially missing out on the attractive return opportunities of this asset class for the wrong reasons.


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The views expressed herein are those of the manager at the time and are subject to change. Past performance is not indicative of future performance.
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