Emerging Market Debt - To hedge or not to hedge?
Emerging Market Debt - To hedge or not to hedge?
Amid persistent low interest rates in developed countries, Emerging Market Debt offers investors diversification and the potential for attractive returns.
Snapshot of Emerging Market Debt
Emerging Market Debt (EMD) is often considered a complex asset class because it incorporates four bond sectors and currencies in over 40 countries. However, it is precisely these characteristics that present significant opportunities for Australian investors. Persistent low interest rates in developed countries offer the potential for meaningful diversification and highly attractive returns, making EMD a potentially valuable addition to an investment portfolio.
The EMD asset class can be broadly divided into Local Currency and Hard Currency Debt, also known as External Debt. These categories can then be further divided into Sovereign Bonds and Corporate Bonds.
We’ve provided descriptions of these sectors in the table below.
|Local Currency Sovereign Debt and Local Currency Corporate Debt||The largest and most liquid sector of EMD. It offers attractive yields in countries with developing capital markets and is often uncorrelated to developed market interest rate cycles.
Local Debt can be held along with currency exposure, or the currency can be, although hedging can partially or completely negate the additional yield. This sector displays higher volatility and highly differentiated returns, so active management is advisable.
|Hard Currency Sovereign Debt||These are bonds issued by emerging market countries in hard currencies predominantly in USD. This sector is less volatile than Local Debt due to the lack of emerging market currency risk. These countries tend to have lower credit quality than local currency countries on average and therefore are considered a credit allocation. This sector has suffered deteriorating secondary market liquidity as brokers have, since the financial crisis, been unwilling to devote capital to supporting these markets.|
|Hard Currency Corporate Debt||The fastest growing sector of EMD. Hard Currency Corporate Debt can occasionally have a higher credit rating than the country where it is based and can offer USD bond access to countries that do not need to issue USD sovereign debt (e.g. China). However, this sector involves interest rate, spread and credit risk and generally very poor secondary market liquidity - particularly during periods of wider market sell-off.|
In contrast to 20 years ago, Local Currency Debt is by far the largest sector EMD. Comprising 85% of the EMD market as at 31 July 2019, the Local Currency Debt sector is split almost equally between Sovereign Debt and Corporate Debt, at 43% and 42% respectively.1
Of the remaining 15% of the EMD market, 10% is made up of Hard Currency Sovereign Debt and 5% of Hard Currency Corporate Debt.1
Local Currency Sovereign Debt is available from a wide range of emerging market countries. Unlike external sovereign debt, which is primarily a credit play, local currency bonds remain largely driven by views on local inflation and local interest rates. As the chart below shows many of these still offer attractive real yields (after inflation) in comparison to developed market bonds where real yields are either very low or negative. As these economies mature, inflation is expected to fall causing rates to converge downwards over time, similar to what occurred in South Korea and Taiwan.
Currency exposure: to hedge or not to hedge?
One of the main considerations with investing in EMD is deciding how to manage the currency exposure. For Australian investors, hedging allocations to USD-denominated Sovereign and Corporate Bonds back to AUD has made sense in recent years. While the USD hedging cost has increased, it remains low at less than 1%.
When it comes to investing in Local Currency Debt, the investor must decide between:
- hedging the emerging market currency exposure (passively hedged);
- hedging the whole allocation as a USD exposure (given this is likely the base currency of the vehicle they are using);
- leaving the exposure unhedged; or
- leaving the allocation unhedged and actively managing the currency exposure.
Each approach brings an entirely different risk/reward dynamic. We’ll discuss the implications of each option in turn.
Option 1 – Passively hedged
Typically, investors allocate to emerging markets to benefit from the far higher yields available in local currency bonds. For example, as at October 2019, Mexico is rated A- by S&P, which is the same credit rating as Spain, but Mexico’s 10-year government bond yields around 7% in local currency terms versus Spain’s paltry 0.2%.
Passively hedging emerging market FX is expensive and would cost on average around 4.5% p.a., using the Bloomberg Cumulative EM-8 Carry Trade Index, plus USD to AUD hedging costs as a proxy. Using the Mexico and Spanish 10-year government bonds as an example, if an Australian investor hedged the currency back to AUD it would reduce Mexico’s hedged yield to a mere 0.2% and see Spain’s hedged yield jump to a more attractive 2%.
As the chart below shows, this approach removes most of the attractive yield on offer from Local Currency EMD. However, this doesn’t mean that all Local Currency EMD looks unattractive on a passively-hedged basis. Most investments will still yield more than their developed market counterparts after hedging (Germany, Australia and the US included below for reference). Plus, given higher real yields, they potentially offer more chance of capital appreciation because yields have more room to compress.
Alternatively, investors can choose to invest in higher-quality emerging markets – such as Korea, Taiwan, Malaysia, Chile and Poland. These markets offer similar portfolio protection to other Sovereign Bonds in the developed world, plus slightly higher hedged yields. This will allow a greater yield pick-up than simply investing in developed market Sovereign Bonds, however investors will lose the potential return advantages and diversification benefits of unhedged local currency exposure.
Option 2 – Hedged as a USD exposure
Most views on emerging market currencies are relative to the USD, which makes the task more complicated for non-USD investors. This can often dissuade investors, as they don’t believe they have the expertise to determine the attractiveness of emerging currencies versus their base currency.
Alternatively, they may believe that by simply hedging the overall exposure as a USD investment, it’s possible to receive the investment return outcome experienced by a USD investor without worrying about the base currency. While there is logic in the latter, Australian investors would be giving up potential return and diversification benefits in doing so.
Option 3 – Unhedged
An option chosen by many investors is to leave the currency unhedged to take advantage of the higher yields available in emerging markets. Unhedged Local Currency EMD can offer attractive diversification for a portfolio, but with this comes far greater volatility than hedged exposures.
Unhedged Local Currency EMD can offer attractive diversification for a portfolio, but with this comes far greater volatility than hedged exposures.
For this reason, investors typically chose an unhedged allocation for one of two reasons:
- they believe emerging market currencies are likely to be stable or appreciate; and
- they believe any depreciation will be less than the yield compensation over the investment horizon.
From a USD perspective, around 60% of the volatility of Local Currency EMD comes from the currency component. This means the majority of the investment rationale comes down to the investor’s view on currencies.
In recent years, overseas investors have increasingly funded their Local Currency EMD exposures through commodity currencies, such as the AUD. This has allowed USD investors to increase their yield by 0.5-1%. More importantly, these currencies are highly correlated with the underlying emerging market currencies.
Relative to other G10 currencies, Australia has had the highest correlation with EM FX, with a correlation above 0.8 over the past nine years. Over the past year, AUD had the third highest correlation (beaten by NZD and NOK), mainly because domestic worries caused the AUD to underperform emerging market currencies by over 4%.
So what does this mean for Australian investors? The high correlation means that most of the currency risk associated with investing in EMD is removed – allowing Australian investors to benefit from the higher yields in emerging markets, with less concern about currency depreciation. This allows AUD investors to experience some of the lowest volatility from investing in unhedged Local Currency Debt.
High correlation means that most of the currency risk associated with investing in EMD is removed – allowing Australian investors to benefit from the higher yields in emerging markets, with less concern about currency deprecation.
Another benefit of this correlation is that it allows Australian investors the potential to earn the most attractive Sharpe ratio relative to their developed market peers. As the tables below show, as well as enjoying lower volatility, AUD investors earned a Sharpe ratio of +0.46 over the past five years relative to USD investors’ -0.18.
In a practical sense, the higher Sharpe ratio of unhedged Local Currency EMD in AUD makes it an attractive inclusion in a portfolio – especially combined with its benefit of being relatively uncorrelated to other asset classes.
For example, the hedged Government Bond Index – Emerging Markets (GBI EM) has a five-year correlation with US High Yield of 0.59, whereas the unhedged GBI EM is only 0.22. The only asset classes where unhedged has a higher correlation than hedged is with Australian Credit, Australian Sovereigns and Global Equities, however in all of these instances the correlation is still negligible at 0.3 or below.
Option 4 – Actively managed currency exposure
While leaving a currency exposure unhedged has yield and diversification benefits, it may subject the portfolio to significant volatility. On top of the volatility of emerging market local currencies against USD, there is also considerable dispersion between the currencies and periodic individual maxi-devaluations do occur (for example, Turkey and Argentina in 2018). This can result in significant capital losses.
A solution to deal with this is to use a manager who actively manages the currency exposure in an unhedged investment. By increasing and reducing hedges in line with perceived risks, they can help avoid such devaluation “accidents”. Actively managing currency exposure allows the investor to benefit from the advantages of Local Currency EMD while significantly reducing the downside volatility of an unhedged approach.
Actively managing currency exposure allows the investor to benefit from the advantages of Local Currency EMD while significantly reducing the downside volatility of an unhedged approach.
If FX exposure is considerably more volatile than bond exposure in the same countries, and trading is very much cheaper and more liquid, a more active approach to managing FX exposure makes sense. A manager may hedge directly into AUD, but it is more likely they will manage the currency exposure so as to maximise returns in USD. In that case, an Australian investor will simply manage the USD/AUD risk of just their USD allocation or hedge the entire allocation as discussed in Option 2. Then, even if that risk is fully hedged, the Australian investor will still benefit from an appreciation of Local Currency EMD against the USD.
Hard Currency Debt
The options we have discussed above all relate to Local Currency Debt. Below we have set out the advantages and disadvantages of hedging USD denominated Hard Currency Debt.
Stand-alone hard currency allocation
Hard Currency EMD (USD denominated) is a credit instrument where return is expected from earning a spread above US Treasuries, or from capital appreciation due to spread compression.
USD Sovereign and Corporate EMD are currently yielding a spread around 300bps above US Treasuries, placing them between US Investment Grade Bond’s 120bps and US High Yield Bond’s 400bps. However, some commentators now believe that spread widening from today’s historically tight levels is a distinct risk.
Unhedged Hard Currency Debt allocations would see return and volatility driven predominantly by the AUD/USD exchange rate. Given that currency hedging costs, although not as attractive as in recent years, are relatively cheap, many Australian investors choose to hedge any stand-alone Hard Currency Debt allocations back to AUD.
Given that currency hedging costs, although not as attractive as in recent years, are relatively cheap, many Australian investors choose to hedge any stand-alone Hard Currency Debt allocations back to AUD.
Tactical hard currency exposure
Some active managers will dynamically tilt their exposure to either local currency bonds or hard currency debt depending on their view on EM currencies.
Aside from the fundamental reasons for buying USD EMD, active local currency managers will also view Hard Currency Debt as a place to hide if their view on emerging currencies is under threat. Increasing their exposure to USD will be done by either selling Local Currency EMD and buying USD Hard Currency EMD, or by simply hedging the Local Currency Debt back to USD (as discussed in Option 4 above), achieving a synthetic Hard Currency Debt. This can help limit drawdowns and volatility during times of currency stress.
This approach muddies the waters somewhat for a non-USD investor. However, for Australian investors, there are some benefits to leaving this tactical Hard Currency Debt allocation unhedged.
USD emerging market Sovereign Debt will typically see their spreads widen during times of USD strength. This is because their credit quality decreases as their ability to repay their debt deteriorates.
Governments will receive tax revenues in their local currency, but if they issue USD debt they will see their interest payments increase as the USD appreciates. This can potentially cause a ‘balance of payments’ crisis.
Given the strong correlation between emerging market currencies and the AUD, the USD tends to appreciate against the AUD during times of emerging market stress. This results in a loose correlation between the USD/AUD and the spreads of emerging market Sovereign Debt, as can be seen in the table below. However, it could be misleading to focus too much on the strong return that unhedged USD EMD has had in AUD terms over the past five years, so these results should be considered with this in mind.
The AUD has depreciated against the USD more than 6% per annum over this period, drastically overpowering any return contribution from the asset class itself. Therefore, it is more useful to look at how returns may be impacted during times of stress.
In the chart below we track two hypothetical portfolios – computed daily, but rebalanced monthly. Both invest 50% in Local Currency EMD (unhedged in AUD) and 50% in Hard Currency EMD (either hedged or unhedged in AUD).
Given the strong rally in the USD against AUD over this seven-year period to 31 August 2019, it isn’t surprising to see that the portfolio with the Emerging Market Bond Index (EMBI) allocation unhedged outperforms. However, if we focus on drawdowns of the portfolio where EMBI is hedged and compare it with the difference in drawdowns from the portfolio where EMBI is unhedged, we can start to see where the benefit is more pronounced.
Having an embedded USD/AUD allocation via the unhedged Hard Currency Debt helps reduce drawdowns during times of emerging market stress quite significantly. This was most pronounced during the Taper Tantrum in 2013 and the Emerging Market Crisis in mid to late 2018. There are also periods when this strategy detracted, such as the ‘risk-on’ rally of 2017.
While any stand-alone USD EMD allocation should be hedged back to the base currency, there are definite benefits of having tactical unhedged USD exposure as an Australian investor during times of emerging market stress. Choosing an active manager who will determine the optimal balance of EM FX and USD, based on their in-depth knowledge of EM currencies, should help limit drawdowns and reduce volatility.
Using an Absolute Return approach
Given our current low interest rate environment, the move away from beta to more flexible and activelymanaged strategies in fixed income is a major trend that we expect to become more prevalent over the next few years.
The ‘carry trade’ driven by the past deflationary environment has encouraged herd-like investment behaviour and led to risk concentration. Worryingly, it has also been accompanied by a decrease in trading volumes and an unprecedented deterioration in the liquidity of credit markets, especially Hard Currency EMD. Thus a reversal of this trend by policymakers and market participants is unlikely to occur without a major financial accident and/or an inflation scare.
We believe that an active, flexible, opportunistic and risk-controlled approach to managing both bonds and currencies – with a particular focus on liquid assets – will be required to succeed in the challenging period that lies ahead. This is why we endorse using an absolute return strategy.
An active, flexible, opportunistic and risk-controlled approach to managing both bonds and currencies will be required to succeed in the challenging period that lies ahead.
Navigating the regular boom and bust cycles
Traditional investing in EMD means a rollercoaster of highs and lows. Most index-relative strategies have seen high volatility and severe drawdowns in excess of 25% during periods of emerging market crises.
We believe there are four key stages of the long-term boom and bust economic cycle in emerging markets:
- Equilibrium - A period of sustainable growth, controlled inflation and strong competitiveness.
- Blind run – Debt-fuelled growth accompanied by inflationary pressures and a high current account deficit.
- Crisis – A period characterised by devaluation, forced monetary tightening and a credit crunch.
- Adjustment – Trade deficit eliminated with a peak in inflation and regained ability to ease monetary policy.
An absolute return strategy takes full advantage of these regular boom and bust cycles in emerging markets. It will typically hold elevated levels of cash and increased currency hedging during the crisis stage of the cycle, and then invest aggressively without currency hedging when the cycle is in its adjustment or equilibrium stages.
Schroders’ approach to EMD
EMD is clearly a highly dynamic asset class that offers many benefits to Australian investors, but it comes with complexities that must be managed carefully by investors or their managers to get the most from their investment. The decision whether to leave the allocation unhedged, actively manage the currency exposures, hedge the individual emerging market currencies or simply hedge the whole allocation as a USD exposure will be a key driver as to the end outcome.
We expect EMD to experience growing differentiation in performance between countries and sectors of the market. At present, while Hard Currency Debt appears to be priced for perfection, selected Local Currency Debt and currency markets are well-positioned to generate handsome returns in the next five years. Therefore, a flexible strategy is required to allocate selectively to pockets of value in EMD.
In our multi-asset portfolios, we have utilised an EMD absolute return strategy as an attractive solution for our Australian investors. This strategy actively manages the currency exposure to its USD base and we evaluate our overall portfolio USD exposure for currency risk. Given the low level of interest rates, rather than a beta allocation, we prefer a more flexible and actively managed strategy with a focus on downside risks and liquidity.
If you would like to know more about Schroders’ EMD strategies, please contact your Schroders representative.
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