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.