* Domestic currency notes hit by volatility
* Observers split over outlook for the asset class
* Eurobond market shut for domestic-currency issues
By Davide Scigliuzzo and Abhinav Ramnarayan
LONDON, June 7 (IFR) - Investors have placed their bets on emerging markets local currency bonds this year, but rising US Treasury yields and currency weakness across a number of emerging economies have led to a sharp correction over the last two weeks and could spell further trouble for the asset class.
As the chase for yield intensified over the last few months, emerging market investors ramped up their exposure to domestic currency assets, channelling net inflows of USD15.7bn into local currency bond funds this year, compared with just USD1.4bn for hard currency funds.
These figures reveal a sharp reversal of the trend observed last year, when local currency funds attracted USD11.6bn of net inflows, roughly half of the USD21.7bn that flowed into hard currency funds.
However, fears that the Federal Reserve might soon start to reduce the pace of its bond buying programme have put the brakes on investors’ search for yield. In the week to June 5, local currency funds experienced outflows for the first time since last July, at USD343m.
Meanwhile, in the FX market, several currencies, including the Mexican peso, South African rand and Turkish lira have taken a beating over the past couple of weeks as investors become increasingly nervous about economic and political risks as well as a deteriorating technical picture.
While both local and hard currency EM bond indices have posted losses of around 3.5% since the beginning of the year, the former has borne the brunt of the recent spike in volatility.
Emerging markets local bond indices lost 7.15% in May, according to hedge fund Finisterre, with hard currency debt dropping 3.57% over the same period.
“In retrospect, it is quite clear that positioning in local bond markets has been excessive,” said Benoit Anne, head of EM strategy at Societe Generale. “There is now anecdotal evidence that long-term investors have started selling. That may suggest that more pain is on the way.”
That view is shared by many in the market, with some arguing that the recent sell-off could just be the beginning of a major reversal of fortunes for emerging market bonds.
In a grim portrayal of the risks facing the asset class, Deutsche Bank warned this week that the strong technicals that have supported EM credits - abundant liquidity and low rates - might be on the brink of a ‘great unwind’.
Countries with large foreign financing requirements - such as South Africa, Indonesia and Turkey - or with a high proportion of domestic debt owned by foreigners - for example Hungary, Mexico, and Peru - are the most exposed, say analysts.
The South African rand lost 11.5% against the dollar over the last month, while the Mexican peso and the Turkish lira shed 6.5% and 5.1%, respectively, over the same period.
In Eastern Europe, Ukraine and Serbia, which both run current account and budget deficits, appear particularly vulnerable in the context of a broad pullback from emerging markets, according to Tim Ash, head of EM research ex-Africa at Standard Bank.
Investors have taken note, rebalancing their portfolios. “We have... cut exposure to the Polish zloty, while reducing Mexico by 33% and adding a tactical short exposure to Hungary through the FX markets,” Finisterre wrote in a monthly commentary of its sovereign debt fund.
Some observers also point out that risks traditionally associated with emerging markets - such as the possibility that central banks and governments will undertake unorthodox policy measures to manage their currencies - are not reflected by current bond yields.
“When inflows are so strong, investors are not being compensated for the risks they are taking,” said Colm McDonagh, head of emerging markets at Insight Investment. “Some are just being yield tourists.”
Others, however, have a more sanguine view, and maintain that the hit taken by emerging markets, and local currency bonds in particular, is transitory, largely a reflection of flight to safety and dollar strength.
“Local currency bonds have always been vulnerable to risk-off sentiment,” said Brian Coulton, emerging markets strategist at Legal & General Investment Management. “I think the recent sell-off is more temporary and cyclical in nature than a sign of wider problems with emerging markets.”
The sharp decline in the local currency bond indices is more of a temporary correction than a complete re-alignment of the asset class, said Peter Wilson, a portfolio manager at Wells Fargo Asset Management.
“There has been a sharp correction, but we certainly believe that the underlying fundamentals support those markets, and we are not concerned or getting out of them,” he said.
In some of the countries, the fall has been for political reasons rather than economic ones, he said, citing the example of civil unrest in Turkey and the IOF tax in Brazil.
Nor is all of the selling attributable to the feared tapering of the asset purchase programme in the US: some of it has been driven by investors such as Japanese retail accounts looking to book profits, he said.
In international primary markets, where a more positive backdrop earlier in the year allowed some Russian and Turkish issuers to raise funds in their domestic currencies, the tide has already started to turn.
Borrowers have struggled to print local currency Eurobonds in recent weeks, with bankers warning that the market is effectively shut for these kinds of trades.
In Russia, telecom company MTS successfully priced a new 10-year US dollar bond in May, but was forced to postpone a rouble-denominated tranche because of adverse market conditions.
Another borrower hoping to lure investors with a rouble Eurobond, Russian Agricultural Bank, is yet to bring its planned offering to the market, after completing investor meetings last week. (Reporting by Davide Scigliuzzo and Abhinav Ramnarayan; Editing by Sudip Roy and Julian Baker)