A winning bearish dollar bet: local currency emerging market bonds

NEW YORK — One of the best strategies to cash in on the dollar’s slide since Donald Trump’s election victory is a rather exotic one: buying local emerging market currency bonds.

Investors who doubted Trump could quickly deliver promised tax cuts, big spending and better trade deals — and by doing so boost the dollar — are now reaping handsome returns from their emerging markets (EM) investments while the dollar wades near 2-1/2-year lows.

Those investors also viewed as overdone fears that economies like Mexico would suffer from Trump’s protectionism and were buying during the post-election emerging markets sell-off.

“It was what he had to say to get elected, given his space and the people he was talking to,” said Federico Garcia Zamora, who manages the Dreyfus Emerging Markets Debt Local Currency Fund. “But it made no economic sense,” he said of Trump’s pledges to scrap the North American Free Trade Agreement, build a border wall with Mexico and slap tariffs on Mexican or Chinese products.

Between the Nov. 8 presidential election and its low point on Dec. 2, JP Morgan’s Emerging Market Global Bond Index fell 6%, Reuters data shows. Mexican bonds suffered the most, and the peso hit a record low.

“Our view was that ( Trump‘ s) economic threats were not credible,” Garcia said. Acting accordingly, he increased his holdings of pesodenominated Mexican bonds and the fund he manages has outperformed 90% of its peers so far this year, according to Morningstar Direct.

Investors generally favor emerging countries’ government debt issued in dollars because it eliminates the risk that their returns might get wiped out by swings in the local currency. Consequently, almost $332 billion were invested in those in mid-2017 compared to $137 billion in local currency bonds, according to research firm eVestment.

But those who stuck with the latter ended up with superior returns. So far this year, emerging market local currency bonds on the

Bloomberg Barclays index have provided a total return of 13.48% compared to 7.77% for hard currency bonds. The US aggregate bond index has returned 3.40%.

WEAK DOLLAR BETS

All 20 of Morningstar’s top 20 highest performing emerging market funds this year have been local currency exclusive or overweight in local currency. Some of the best returns for multi-sector funds have been boosted by local currency bonds.

Reuters interviewed half of the 20 top performing funds’ managers and they are sticking with those bets, convinced that the dollar will remain weak. The dollar index is expected to end the year down more than 7%, its worst annual performance since the financial crisis, according to a recent Reuters poll of economists.

The dollar’s slide reflects both investors’ disappointment with the lack of progress on US economic policy and other central banks’ steps to end to their ultraloose monetary policy, which made currencies like the euro become more attractive.

David Aniloff, portfolio manager for global fixed income strategies at asset manager SEI, said doubts about Trump’s agenda prompted him to gradually increase emerging markets allocations.

Aniloff said he had typically split his emerging market bond exposure 50/ 50 between hard and local currency bonds, but that split was most recently 65-35 in local currency bonds’ favor.

“We are about as large an overweight to EM local currency bonds and currencies as we have been in several years,” Aniloff said. SEI is among the best performing emerging market debt funds this year with data showing one fund beating 98% of its peers and another outperforming 97%.

Fund managers also say many emerging economies have bolstered their financial markets, making them more resilient during cyclical downturns and thus less risky than in the past.

“It’s a great opportunity to buy into emerging markets,” said Ricardo Adrogue, head of emerging markets debt at Barings.

Adrogue’s Emerging Markets Local Currency Debt Fund is up around 20% so far this year, beating 99% of its peers.

Kathleen Gaffney, co-manager of the Eaton Vance Multisector Income Fund, said the fund last held roughly a quarter of its assets in foreign securities. Non-US currency investments — including those in Mexican, Brazilian, Indian and Indonesian local currency bonds — accounted for half of the fund’s outperformance. The fund is beating 97% of funds in its peer group year- to- date, Morningstar’s data show.

“It’s the currencies that offer the most total return potential,” Gaffney said.