Beware Quick Drop in Local-Currency Emerging-Market Debt: Gadfly

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Beware Quick Drop in Local-Currency Emerging-Market Debt: Gadfly
Credit: © Reuters.

(Bloomberg Gadfly) -- One of this year’s biggest debt-market winners is facing a big test.

Local-currency debt of developing nations has hit a rough spot after gaining nearly 12 percent during the first nine months of the year. It has fallen nearly 3 percent since Sept. 8 even as other riskier assets such as U.S. high-yield bonds and stocks gained value.

The most obvious reason is that the U.S. dollar has strengthened a bit since then, with emerging-market currencies falling nearly 2 percent.

The Mexican peso and Turkish lira , for example, have fallen by more than 8 percent in the period. This is a marked shift from earlier in the year, when emerging-market currencies collectively gained nearly 10 percent against the dollar.

These recent losses are relatively small in the scheme of things. But they present an important reality check to credit buyers, who have piled eagerly into these securities throughout the year, often through broad index funds.

They've been alluring for their higher yields and currency-related gains. They are often viewed as largely a credit investment. But these securities are ultimately a leveraged dollar bet with some credit risk thrown in.

So the question is, just how much value does this debt have to lose before tourist investors stampede out the door? So far, the losses haven't been that big, and the biggest exchange-traded fund that invests in these bonds has continued to receive inflows.

At a certain point, however, if the dollar keeps strengthening, these bonds are going to lose enough value to push away some foreign investors, especially those who plowed in through index funds simply to generate higher returns.

Asset managers have argued that developing economies are stronger and more independent from the whims of U.S. markets than ever before. This could very well be true.

But that won't prevent a painful, dollar-driven selloff in local-currency emerging-market debt. If investors respond to losses by yanking cash from broad index funds, this could get ugly.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

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