Emerging market local currency debt funds are all the rage, but they offer little value at present.
[This article first appeared on our sister site, IndexUniverse.eu.]
The success of U.S.-listed exchange-traded funds tracking the domestic debt of emerging market economies has prompted European issuers to follow suit.
As my colleague Olly Ludwig wrote this week on our sister site, IndexUniverse.com, Market Vectors’ Emerging Markets Local Currency Bond ETF (NYSEArca: EMLC) and WisdomTree’s Emerging Markets Local Debt Fund (NYSEArca: ELD) are right on trend with investors at the moment, having gathered a collective US$1.5 billion in assets since their launches last year.
On this side of the Atlantic, we’ve seen two similar funds appear in 2011, and I hear that more are in the pipeline. A few months ago SPDR Europe launched its Barclays Capital Emerging Markets Local Bond ETF (Xetra: SYBM), while iShares released the Barclays Capital Emerging Market Local Govt Bond ETF (LSE: SEML) in June. Each fund now has over US$50 million in assets.
According to Jan van Eck, head of Van Eck Global, the managers of EMLC, recent concerns over European default and the US debt ceiling only serve to reinforce the attractions of the local currency debt of developing economies.
“Couple the [debt] issues in the US with [the ratings] downgrades that have already taken place in developed Europe, and contrast that with emerging market countries that have worked to strengthen their economic policies and to improve their credit profiles, and emerging market local currency bonds look potentially quite appealing,” Mr Van Eck told the Financial Times for an article published yesterday evening.
But is this the right time for investors to be gaining access to the sector? I think not.
Why? First, buying local currency emerging market debt right now means purchasing currencies that, in some cases, are severely overvalued.
Take Brazil, which constitutes 17 percent of iShares’ SEML and 10 percent of SPDR Europe’s SYBM. According to the Economist’s Big Mac index, Brazil’s real stands out by some way as the world’s most overvalued currency (by 52 percent on a “raw” basis, converting the cost of a Big Mac in reals to that in US dollars using the current FX rate, or by 149 percent if you adjust for differences in GDP between the two countries).
If you prefer a less flippant measure of valuation, the IMF has been saying the same thing for a while, while Brazil's finance ministry has been discouraging capital inflows through successive hikes in taxes.
Other emerging market currencies may not look so expensive, says the Economist, even if in most cases they are not particularly cheap, either.
However, there’s a second reason for caution on the valuation of domestic emerging market bonds. Many countries in the ETFs launched over the last year face inflation problems, meaning that rates should be heading up, rather than down.
According to Philip Poole, head of investment strategy at HSBC Global Asset Management, key emerging market economies like Russia and India are too slow in raising rates to combat domestic inflation. Further, says Poole, quoted in Hedge Fund Review, emerging market inflation pressures are more deep-seated than commonly thought, arising from high capacity utilisation levels and low unemployment rates, and not just as a result of recent commodity price increases.
One bullish case for emerging market currencies is that rising interest rates may attract more inflows from abroad, pushing FX rates higher. Of course, if you’re also investing in the local debt markets you’ll suffer capital losses as rates rise. But chasing local currencies higher in overheating economies where interest rates are rising is a risky game to play, as such trends are likely to end in a rapid reversal.
The appearance of local currency emerging market debt ETFs is good news for investors, as this is a useful new asset class for issuers to cover. But I’d be wary of buying this sector now, near what could be a top in emerging bond markets’ valuation.