June 2023 / INVESTMENT INSIGHTS
Inside the Engine Room of EM Local Currency Debt
A potentially rewarding asset class
- The volatility of emerging market local currency (EMLC) debt falls significantly with the holding period. This means that investment time horizon is key when investing in the asset class.
- The importance of coupon, price appreciation, and currency to total returns changes with the time horizon. Currency dominates the short run, while coupon dominates the longer term.
- The current attractive yield level of EMLC debt provides a good entry point for investors with over three-year investment horizons.
Emerging market local currency (EMLC)1 debt is a complex asset class that can behave quite differently over different time horizons. This can make it challenging for investors to analyze the opportunity that it offers. In this paper, we take a look at how investors might frame the opportunity more clearly, exploring alternative ways to think about the risk and return drivers of what is potentially a rewarding asset class.
EMLC debt is essentially a government bond investment, driven by currency and sovereign risk. It may be thought of as a higher-yielding, higher-risk extension of an investor’s global government bond allocation rather than being solely part of an EM allocation.
The starting point for any analysis is recognizing that the total return to investors in EMLC debt consists of three distinct drivers: coupon, price appreciation, and currency (FX). We’ll begin by looking at the impact of time horizon on EMLC debt investment outcomes and the role played by the different return drivers. We’ll then discuss some underlying dynamics of the three return drivers, seeking to draw investment implications for asset owners and asset managers along the way.
While elevated within short periods, the volatility of EMLC debt falls significantly as we extend the holding period. This means investment time horizon should be one of the first decisions to make when thinking about investing in EMLC debt.
The relative importance of the three underlying drivers—coupon, price appreciation, and currency—to total return changes dramatically depending on the time horizon: Currency is the largest driver in the short run, but coupon becomes the dominating factor over time. While investors cannot cleanly access the three components of EMLC debt returns separately, they can actively tilt their exposure toward or away from one or more return drivers.
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