Emerging local debt: hedges needed
The fierce sell-off that hit emerging market local currency debt last month was possibly down to low levels of currency hedging by investors, JPMorgan says.
Analysts at the bank compare the rout with the one May 2012, caused by exactly the same reason — higher U.S. yields. There was a difference though — back then EM currencies dropped more than 8% on the month but EM local bonds, unlike last month, were little changed.
Gauging hedging levels is usually a tricky business. But JPM uses the results of its monthly client surveys to analyse the differing moves:
Flows to EM local markets were muted throughout 2012 and investors regularly employed high FX hedge ratios of EM bond portfolios, but investors shifted stance in 2013…..EM FX hedge ratios were low entering the sell-off, having fallen below 10% relative to 25% in May of 2012.
The lower level of hedging gels with investors’ return expectations going into 2013, the bank said. Its survey back in November 2012 revealed that investors expected total returns from local markets of 7-10% versus 5-7% for EM sovereign and corporate credit. And within local markets, investors were banking on currency appreciation to deliver around half the total returns.
That, according to JPM, explains the relatively lower hedge ratios employed by GBI-EM investors. The bank adds:
Given the relatively high liquidity of many EM currencies, it is not surprising that this asset class has borne the brunt of the recent move, with EM bonds likely suffering as EM FX losses mount and pressure from the U.S. Treasury sell-off increased.
JPM notes two other factors that might be contributing to the sell-off. First, flows into emerging debt have favoured domestic rather than hard currency bonds (different from last year’s trend). Second, the correlation and beta between EM local yields has increased substantially compared to last year.
What next though? JPM analysts say that if the next set of U.S. jobs data does validate momentum in the U.S.economy, it will be hard to make a case for owning EM currencies or being long local market duration. Meanwhile, they recommend at least partially hedging the currency component of emerging debt investments.