* Asset managers seek returns in local currency
* Growing liquidity makes investment more attractive
* Bankers say corporate bonds are the next target
By Christopher Langner
Feb 25 (IFR) - Credit investors are turning to local currency corporate bonds to generate better returns after a prolonged rally in US-dollar debt left little upside.
Michael Gomez, co-chief investment officer at Pimco, manager of the world's biggest bond fund, has written that local emerging markets "stand out as continuing to offer significant value" relative to alternatives from the developed world.
Gomez said EM debt denominated in US dollars now looked "either just fair or rich versus other comparable credit alternatives" and that "it is hard to find a 10-year maturity investment-grade bond where credit quality is still on an improving trajectory that pays 4.5%".
His comments in an article, titled "The Year Past, The Year Ahead", were published on the Pimco website.
Pimco is not alone in targeting local markets. Fund flows suggest other investors are thinking along the same lines. EM local currency funds have taken in a cumulative net inflow of US$5.7bn this year, until mid-February, according to EPFR Global. That is five times more than the allocations to EM hard-currency bond funds in the same period.
"All the big guys have been paying more attention to Asian local corporate markets," said Vishal Goenka, head of local credit markets trading for Asia at Deutsche Bank in Singapore.
Betting on local currency bonds is nothing new to the world's largest asset managers - and the gamble has mostly paid off. In 2005, BlueBay set up its EM local currency bond fund. That fund has returned 68.44% since January 2009 and 18.5% since January 2012. This compares with returns of 47.2% on Merrill Lynch's dollar-denominated EM sovereign bond index since January 2009 and 11.5% since last year.
Pimco and Western Asset Management (Wamco) both have funds dedicated to EM local government bonds. Ashmore has been touting the benefits of the asset class since 1997, when it launched its local currency debt portfolio.
In its 2013 outlook, Ashmore renewed its pitch for EM local currency bonds. "Local currency government bonds pay nearly 500bp more than equivalent-duration US Government bonds. Correlation with US Treasuries is very low, and volatility of yields is lower. The universe is 90% investment grade and set to reach a size of US$20trn at the end of this decade."
While global funds have long invested in local currency debt, they have largely stayed away from local corporate bonds, preferring less risky government securities. Local regulations and taxes have also been a hurdle: countries like India, Brazil and even Single A rated South Korea have used limits and taxes on foreign money as a currency-control tool several times in the past five years.
Corporate bonds can be risky investments, but the growing liquidity in the world's local currency markets - offering the possibility of an easier exit - is tempting global asset managers to overcome their fears.
Deutsche's Goenka pointed to the rapid growth in some major Asian markets as proof that they had become more liquid and, hence, a tad safer. He estimated that the South Korean corporate bond market had some US$777bn equivalent outstanding as of October, with China close behind at US$650bn, Malaysia US$118bn, Singapore US$120bn and India US$200bn.
According to Thomson Reuters data, corporate bond issues last year totalled US$440bn in Asia, excluding Japan and Australia - almost four times as much as the amount companies raised in dollar-denominated debt in the region. More bonds mean better liquidity.
In its latest quarterly bond market report in November, the Asia Development Bank also noted the liquidity improvement. "Bid-ask spreads for both government and corporate bonds tightened in most markets in 2012, while average trading sizes also increased."
Yet, according to the ADB, the average transaction size in the secondary bond market is just US$9m in South Korea, US$7m in China,US$2m in India, US$1.1m in Singapore and Thailand, US$600,000 in Indonesia and US$500,000 in the Philippines. That is still far short of the sizes the biggest global fund managers are looking to trade.
Nevertheless, at a time of ultra-low dollar yields, the high returns local corporates bonds offer may have become too hard to pass up. According to Goenka, the average blue-chip corporate bond in India returns some 125bp over government-securities, which themselves already have nominal yields more than 550bp higher than US Treasuries.
As Pimco's Gomez wrote: "While negative real rates out to 10 years are an unfortunate reality for many developed world sovereign debt investors, most EM local markets continue to operate with positive real policy rates and provide investors the opportunity for attractive carry and roll down further out the curve."