How Currency Impacts Emerging Market Bond Investing

Currency depreciation can have very negative impact on balance sheets of sovereign bonds, and of corporates. But if can create investment opportunities too

Emma Wall 10 July, 2017 | 11:59AM
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This article is part of the Morningstar's Guide to Emerging Market Investing. Click here to find out just what an emerging market is and which regions hold the potential to boost your investment portfolio.


Emma Wall: Hello, and welcome to the Morningstar series, "Why Should I Invest With You?" I'm Emma Wall and I'm joined today by Claudia Calich, Manager of the M&G Emerging Markets Bond Fund.

Hello, Claudia.

Claudia Calich: Hi, Emma.

Wall: So, I know in the last six months you have moved some of the portfolio more into local currency issued bonds. But I thought we could take a step back and ask what does currency mean for a fixed income investor and how does that play into your investment strategy?

Calich: Yeah. So, currency is quite important for emerging market investing for a couple of reasons. One is the currencies, particularly if you have an abrupt depreciation, could have very negative impact on balance sheets of sovereigns, of corporates, particularly if they happen to be very highly leveraged and of course, the currency that they depend most of their revenues depreciate. So, that's more from a credit standpoint that I would look at.

The other aspect is really the investing in local currency instruments, bonds or currencies themselves. So, this opens up another gamut of opportunities. And as you highlighted, I have actually increased exposure to local currency instruments which is about a third of the fund at the moment from a lowest 10% about two years ago.

And this is much predicated on the risk/reward opportunities of those currencies and primarily with a view that we've seen a very large, finally, a view of depreciation of those currencies a couple of years ago and also, the balances of debt of a lot of those countries suffered; particularly, large current account balances are starting to shrink. So, that should also be supportive for those currencies going forward.

Wall: Bottom line, does that mean that you are feeling more positive about the economic outlook for those countries, because of course when a country's economy does well, then its currency has strength.

Calich: Correct. So, the economic outlook is one way of looking at it. The other one is also monetary policy and inflation pattern in those countries. So, for a local currency bond, of course, the currency is one component of returns, but one we should not also overlook, the interest rate component. And in that case, we've seen quite a bit of inflation picking in a lot of countries that had very large currency depreciations a few years ago, so countries like Russia, Colombia, Brazil and so forth.

So, inflation is at the peak, which means the central banks have already embarked on an easing monetary stance, which is quite different from what we've seen in Eastern Europe and of course, the major central banks, the ECB and the Fed. So, this also gives very good uncorrelated opportunities in the subset of the asset class.

Wall: So, you mentioned a couple of countries there. But perhaps you could highlight somewhere you see – you have real conviction, something that you are very positive on at the moment?

Calich: Yeah. So, within the currency space we're highlighting a couple of very idiosyncratic places. For example, Egypt pound, which arguably is not the most liquid currency out there, but the Egyptian Central Bank finally allowed the currency to depreciate and recently even last night they also tightened rates further because inflation is still rising. So, that should be quite supportive for those local currency bonds.

In terms of more mainstream countries, Russia bonds I think are still attractive. The central bank has been quite still hawkish and intervening – basically removing the monetary policy stance very, very slowly.

There's also opportunities, however, in the hard currency space. So, two-thirds of the portfolio is still within hard currency bonds. So, in that respect, we see opportunities in pockets of Eastern European countries that are benefiting from the recovery that we've seen in the Eurozone, some other weaker countries such as Albania, Macedonia, really exotic type of countries, usually tend to be under-looked by investors. So, we find pockets of value there.

And the other areas, also pockets within Central America, Caribbean, similar regions that when we spoke two years ago, I also mentioned those regions and this shows that in some of these cases you have to look at those countries for the long haul. So, same countries that I was invested two years ago, in some cases, I still have the holdings at the moment.

Wall: Claudia, thank you very much.

Calich: Thank you, Emma.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar

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