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Hard vs local currency EM bonds – focus on credit risk, not FX risk

Thursday, February 26, 2015

Comment from Paul McNamara, Investment Director at GAM.

In recent weeks average yields on EM local currency bond indices, such as the JPMorgan GBI-EM, have declined even as average yields on the EM hard currency indices, such as the JPMorgan EMBI-GD, have increased. The narrowing of the yield spread has caused a number of commentators to conclude that the compensation for holding EM FX risk has become too narrow, and that local currency bonds could underperform in the coming months as a result.

We believe that this view is based on a common misunderstanding about the relative risks that face the hard and local currency EM bond indices. The choice between local and hard currency bond indices is frequently presented as a choice between taking on EM FX risk or not. In our view, given that the hard currency basket (the EMBI-GD) includes far more countries of a lower credit quality, the choice between local currency bonds (as represented by the GBI-EM) and hard currency bonds is more correctly viewed as a choice between taking on EM FX risk and EM credit risk.


Source: Bloomberg - As of 20 February 2015


Source: Bloomberg - As of 20 February 2015

This point has been evident in recent weeks. Yields on local currency bonds have declined and yields on the hard currency bonds have increased (Chart 1), causing the yield spread to narrow. However, the increase in hard currency yields has been driven by increased yields in countries that face material risks of default. Since June last year, yields in the high-yield countries in the overall hard currency basket have increased by 1.71%, whereas the yields on the investment-grade portion of the basket have actually declined. In Venezuela and Ukraine, yields have increased by 17 and 32 percentage points respectively. These countries are not part of the local currency basket, and as a result the deterioration in their outlook has had no impact on local currency yields.

To remove the impact of credit risk you can compare average local currency yields with average yields on the investment grade component of the hard currency basket. These yields have moved in the same direction (Chart 2) and the spread has hardly narrowed at all. The level of compensation for FX risk is in line with its average for the past six years. At an index level, the spread has narrowed because credit risk has increased in the weaker-quality EM names, and it is this credit risk component that investors frequently ignore when they choose between investing in local currency and hard currency EM bonds.

Nothing in this material constitutes investment, legal, accounting or tax advice and should not be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction. The statements and opinions in this material are those of the author at the time of publication and may not reflect his/her views thereafter. Past performance is not indicative of future performance.  Indices cannot be purchased directly.
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