Dollar denominated versus local currency

“The pros of local currency investing are that the investor is able, to a certain extent, to isolate the factors that will drive interest rate markets in a country and therefore it’s less susceptible, in theory, to US Treasury moves or the whims of international capital flows,” he explains. “The more developed the country, the more developed its domestic financial institutions are and the greater proportion of domestic debt is held by domestic investors.”

Mr Simpson identifies Mexico, South Africa and Poland as markets which tend to react more to domestic factors than international factors and have been issuing external debt for many years.

At the other end of the spectrum are those countries that are still going through the development stage. He adds: “[There are] new opportunities in places like sub-Saharan Africa, Central America and parts of Asia. While the domestic institutions are not yet developed enough to issue debt, the international markets are open for them to issue.”

He acknowledges there are risks associated with dollar-denominated debt but counters that for investors it offers an alternative opportunity set from local currency investing.

“The dollar space will remain important but it’s an area where new countries like frontier markets would have their first foray into issuance. A lot of African countries have started to issue for the first time in the past two years so that’s a frontier part of the universe,” adds Rob Drijkoningen, head of the emerging market debt team at Neuberger Berman.

Typically, more advanced emerging market countries will issue local currency debt.

He says: “They need to invest in local currency because it’s conducive to generating mortgage markets, insurance products and so on, which need to be priced off of local yield curves. The government yield curve is instrumental in achieving deeper capital markets and that allows the next phase of development for emerging markets to take place.”

Mr Drijkoningen believes that both currencies have a role to play in an investor’s portfolio. “They are fairly complementary in terms of composition of countries. On the dollar side you have more frontier names than local currency. And also the dynamics of the dollar space versus local currency are quite different, so that is another reason why strategically investors should be invested in both or a combination of the two,” he argues.

In terms of performance, Sergio Trigo-Paz, who heads up the emerging markets fixed income team at BlackRock, predicted at the end of last year and coming into 2014 that hard currency was going to be the top performing fixed income asset class in dollars.

He points to the fact it is outperforming the S&P 500 index.

But the performance of local currency emerging market debt spreads has surprised him.

“So far local currency has performed 2.3-2.5 per cent year-to-date so it’s actually beating my bearish expectations,” he admits. “We are still seeing opportunities in hard currency debt, although they are relative opportunities versus US investment grade and Europe investment grade where the spread is still very attractive. But now I think most of the rally price has happened.”

But MFS Investment Management has a cautious outlook on local currency. The firm states: “With the prospect of Fed tightening in the not-too-distant future, we would stay strategically cautious on local currency, while ready to capitalise on tactical opportunities in the currencies of economies with strong or improving capital and current account balances.”

There are clearly returns to be had from investing in emerging market debt assets so investors may want to look at being exposed to both local currency and dollar-denominated emerging market debt as part of a diversified and balanced portfolio.

Ellie Duncan is deputy features editor at Investment Adviser

LOCAL CURRENCY VS DOLLAR DENOMINATED

Local currency

Countries: More advanced emerging market countries tend to issue debt in local currencies

Pro: Local currency EM debt is not aligned with international markets or any movement in US Treasuries

Con: Local has slightly underperformed hard currency in the past year with returns of 2.3-2.5 per cent year-to-date

Dollar denominated

Countries: Typically, less developed frontier market countries will turn to international markets for issuance

Pro: Hard currency has generally outperformed local currency debt in the past year and can form part of a diversified portfolio

Con: Dollar-denominated debt is, to some extent, at the whim of any movements in international markets