We explained in our global themes and 2023 outlook how proactive rate hikes by EM central banks pushed up the EM-DM real rate differential and partially protected EM currencies from a rising dollar even as the acceleration of rate hikes by the Fed and other DM central banks have chipped away at the positive real rate differential. This piece takes a different perspective by looking at the difference between the yields on local currency (LCY) and dollar-denominated (HCY) debt within countries.
A cursory comparison of the yield of the Bloomberg EM Local Currency Index (excl. China, which otherwise dominates with a 52.5% weight) with that of the Bloomberg EM Sovereign US$ Index shows a similar trend, with the LCY-HCY yield differential rising from mid-2020 to late-2021 as the EM policy rate hiking cycle accelerated and narrowing thereafter as the Fed hiking cycle gathered steam, which pushed up both the risk-free rate and credit spreads and led to a sharp increase in HCY yields.
However, this comparison is imperfect, as the indices contain a highly heterogeneous sample of countries. To make the time series more meaningful, we reconstruct them to include only the 14 countries that are present in both indices (once again excluding China), weighting both indices by LCY market cap. The general picture is the same, but now the LCY and HCY indexes are directly comparable and the LCY-HCY yield differential takes on a positive sign.
While yields on both indices are near historical highs, the LCY-HCY differential has moderated and is now more or less in line with pre-Covid levels, down from a series high of nearly 2.75% in late 2021. This means that the relative attractiveness of LCY EM sovereign debt versus HCY EM sovereign credit has declined since late 2021 but is broadly in line with historical levels.
However, this comparison is also incomplete, covering a subset of just 14 larger EM. We expand our sample to cover 30 EM and compare the 10-year LCY bond yield (proxied by the “generic” 10yr yield or BVAL interpolation) with the 10-year HCY bond yield (proxied by the Bloomberg EM Sovereign Index or BVAL interpolation) on a static, cross-country basis (click through to the web version for the full table):
We assume that, except for special cases, there must be a sufficiently positive LCY-HCY differential to compensate for currency, liquidity and/or legal risk for a country’s local debt market to be attractive (see here for our take on this topic regarding Egypt). From this perspective, very few countries stand out as being attractive, with the differential exceeding 4% in just five countries and 2% in 11 countries, while the differential is negative in over one-third of the sample.
Of the countries with significantly positive differentials, Ghana is a special case due to its ongoing restructuring, currency overvaluation renders LCY debt unattractive in Kenya and Nigeria, and Egypt is in the midst of a sharp devaluation that would have eroded any positive returns (although with the parallel market premium now largely erased and currency backlogs in the process of being cleared, LCY Egyptian debt may soon be attractive).
That leaves Brazil, Colombia, Namibia, South Africa, Mexico, Trinidad and Tobago and Peru as the countries where investors can receive the largest yield pickup for investing in LCY debt over HCY credit. A more detailed analysis is required to identify which countries are most attractive (including analysis of currency valuation and real interest rates), but this table can serve as a screen for identifying which counties do not have a sufficient LCY yield pickup to justify consideration of LCY investment over HCY credit.
Overall, it appears that there is a limited subset of countries with a strong LCY investment case. However, if market expectations of a Fed pivot play out and dollar weakness continues (DXY is down 10.9% since the late September peak and EM currencies are up 6.4% over that period), then even a small or negative LCY-HCY yield differential may prove attractive in certain countries (see our 2023 outlook for a more detailed analysis of what could drive the dollar in the year ahead).