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Closer look at currency returns

Thursday, October 4, 2007
International bonds

AVP, Risk and Research

Investors are finding slim pickings in emerging market US$ Eurobonds with the average spread on emerging market eurobonds over US Treasuries as measured by the JP Morgan EMBI+ Index at just over 200 bps. Spreads did widen to as much as 250 bps following the subprime driven flight to quality and this afforded astute investors an opportunity to pick up higher yielding bonds.

The 50 bps rate cut by Feds Chairman Bernanke has resulted in yields dropping as investors return to emerging market debt. Five years ago these same bonds offered investors a spread of over 600 bps above US Treasuries. Some of the factors that are causing emerging market bond yields to fall may also provide an opportunity for investors.

Fundamentals in many emerging market economies have improved significantly over the past five years driven by high commodity prices, strong global economic growth and sound economic management. This has resulted in strong fiscal and external account positions which have been rewarded with higher credit ratings from the rating agencies.

As credit ratings have gone up, yields have come down.

Currently, an investor will have to go out more than 20 years to get a yield above 6.50 per cent on a BB rated US$ Eurobond.

Many of these emerging market economies have accumulated substantial foreign reserves as direct foreign investments have been flowing into their expanding economies. Economic growth combined with low to moderate inflation rates has given a boost to the currencies of many emerging market countries.

Some countries, such as Brazil, have been prepaying their US$ debt which has helped the currency appreciate even further.

According to market analysts, some of these emerging market currencies have the potential to appreciate further given their strong fundamentals and therefore present an opportunity for investors to pick up attractive returns by investing in local currency bonds.

Governments of countries such as Brazil and Colombia recognise the attraction of local currency bonds to international investors and have tried to make it easier for investors to participate in real and peso denominated bonds respectively. Both countries have issued local currency global bonds that can be bought and transferred in international financial markets and that are not subject to local taxes.

An investor in Trinidad, for example, could buy Brazilian real denominated bonds from a broker in New York and hold it in an account in New York. That bond can then be sold in New York and proceeds received in US$.

The attraction of local currency bonds to international investors are two fold.

Interest rates in the local currency are still attractive as central banks focus on controlling inflation. For example, a Brazilian real denominated 2016 bond yields approximately 9.40 per cent while a 2017 Brazilian US$ Eurobond currently yield below six per cent.

The second and potentially more lucrative return is from currency appreciation where over a short period of time changes in the currency can generate a large percentage return. A nine per cent bond in a stable currency is a good investment. The same bond in an appreciating currency is an even better investment. The Brazilian real has advanced 3.2 per cent since the Fed funds rate cut; even reaching its strongest for 2007 so far at 1.8365: US$. Recently declining to 2.1385 a US$, it has since risen to 1.8450 a US$, appreciating by 6.3 per cent for the month of September alone.

One of the obvious concerns about investing in a local currency bond is the possibility of a severe depreciation in the currency. Emerging market currencies have grown a lot more resilient over the past few years. This is evidenced by the fact that with the recent turmoil in financial markets related to the subprime issues, the sell-off in emerging market currencies was not significant.

Exchange rates move more quickly and by larger amounts in percentage terms than bond prices so anyone taking currency exposure must monitor the market closely.

In addition, not all emerging market countries have issued global bonds so certain currency exposures can only be taken by investing within those countries. For such investments it is important to be aware of all the taxes (both on income and on redemption) before making an investment.

Local-currency denominated bonds have the potential to be the next major investment frontier but investors need to ensure they have the risk appetite for this investment before taking the plunge.


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