* 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
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.
BEARING THE BRUNT
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
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
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
(Reporting by Davide Scigliuzzo and Abhinav Ramnarayan; Editing
by Sudip Roy and Julian Baker)