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Investment ideas

Still some way to go in EM local bond run-up

Drivers include attractive yields, currency upside

After strong gains in recent years, local currency emerging market (EM) bonds could deliver returns of 10-13% a year over the next five years. Foreign exchange flows into EM should stay strong, helping EM currencies rise against the US dollar. We expect these currencies to gain 3-5% a year for the next five years and the winners to include the Kazakh tenge, the Philippine peso, the Colombian peso, the South Korean won and the Russian rouble.

As for yields, currently around 7%, emerging countries have raised interest rates pragmatically and structurally for many months, taking some to the point where they could start cutting rates again. Inflationary concerns may have dampened some enthusiasm for the asset class, but the risks, as well as the worries about overheating, have been exaggerated.

Prefer Latin America over Asia
Latin America stands out as a favourite region whereas Asian local currency debt has been seeing low rates for some time. There are also fewer options in this region, mainly in Indonesia, and there are inflation concerns in countries such as Malaysia and Hong Kong. We are keener on Asian currencies than debt.

Given the market concerns about the Greek sovereign debt crisis, we have been underweight emerging Europe since 2009. Recent reform plans have alleviated some of the concerns for the time being, but this market has been quite volatile and we remain cautious.

In demand
EM bonds have become more popular in the past year as investors look to capture relatively high yields and benefit from currency gains. In terms of investment risk, 80% of EM local bonds in the main benchmark is now investment grade, while the rest – mainly Turkish and Indonesian bonds – could soon make this grade as well. Instead, we see the main risks coming from developed countries including slower growth and ratings downgrades.

The changing risk profile of the asset class is attracting ever more institutional investors. A decade ago, most investors were essentially short-term investors. The investor base is more stable nowadays and in our EM local funds we see that more than 50% of new investors are pension funds or central banks.

This is the abridged version of an article from BNP Paribas Investment Partners – PERSPECTIVES March 2012. Contact your client relationship manager for more information.

William De Viljder's blog