Egyptian, Pakistani, Nigerian, Kenyan and other countries’ local currency debts have been some of the most unloved assets — short of outright defaulted debt — in emerging markets in recent years, as currency crises have ravaged their economies.
But such bonds are now making a comeback, helped by as a series of interest rate rises and moves to liberalise currency markets, as these countries bid to repair their damaged economies.
With interest rates on the way down in some of the more mature emerging markets such as Brazil, investors are finding the double-digit yields on offer in frontier markets too attractive to ignore.
“You are having to reach into slightly more off-piste trades in frontier to really make your money,” said one emerging-market fund manager who has invested in Egyptian T-bills and has also looked at short-term Nigerian naira debt.
“Frontier local currency still gives you carry,” or outsized yields compared with US rates, the manager said. They added that even if the US Federal Reserve only cuts interest rates once this year, frontier markets “will still get you a lot of (yield)”.
In Turkeywhere years of monetary mismanagement had scared investors away, interest rates of 50 per cent designed to tackle double-digit inflation and stabilise the lira have attracted them back this year. Foreign investors’ holdings of lira-denominated government debt have almost quadrupled since the start of the year to around $10bn at the end of May, according to central bank data.
Egypt’s debt has also been a popular trade this year. Foreign investors have poured $15bn into its local bonds, much of it following a $35bn investment by Abu Dhabi’s sovereign wealth fund in an attempt to ease the country’s financial crisis.
The Egyptian pound was devalued this year and has also been allowed to float freely against the dollar, as a way of trying to relieve foreign currency shortages.
Investors believe that similar reforms in Nigeria, Turkey and around two dozen other frontier markets are bearing fruit at a time when returns on other forms of emerging-market debt are falling.
“Policymakers in frontier markets are becoming more savvy,” said Luis Costa, global head of emerging markets strategy at Citi.
The US dollar debt of many of these countries has already rallied as they avoided outright default and many investors doubt yields — which move inversely to prices — can go much lower from here.
Meanwhile, a rally in more creditworthy emerging markets’ local currency debt, driven by rate cuts, is also seen as nearing an end.
Trades in the currencies of some larger emerging markets have also misfired recently, for instance in the sharp sell-off in the Mexican peso after this month’s election.
Jonny Goulden, head of emerging-markets fixed-income strategy at JPMorgan, said investors are trying to avoid just betting on when the Fed will cut rates.
“Within emerging markets, we have a number of countries where there are idiosyncratic drivers,” he said, where a mixture of currency devaluations, interest rate rises, policy reforms and bailout loans help reassure investors.
They tend to be wary of riskier countries’ local debt, which tends to be more volatile and which is tied to the fortunes of the currency. Many investors fear the sudden imposition of capital controls or the prospect of the debt market seizing up during a crisis as foreign investors rush for the exit.
Analysts say that, so far, there are few signs that buying the debt is a crowded trade or that investors are failing to consider the risks. “What we have found is that while positioning has increased, it’s generally not that large,” Goulden said.
While foreigners have hurried back in to Turkey’s lira bonds this year in response to more orthodox economic policies, they still only account for around 5 per cent of the market, down from one-fifth before its 2018 currency crisis. In Egypt, foreign investors hold around one-tenth of local debt. That is higher than a 2022 nadir but well below a peak in 2021.
However, the prospect that US interest rates will stay higher for longer as the Fed battles stubbornly high inflation could prove a headwind for emerging market local debt.
Egypt, Nigeria and Pakistan, which are forecast to spend more than one-third of their revenue on debt interest payments by 2028, are particularly at risk from high US rates as that could force them to keep their own rates elevated in order to attract capital, according to Moody’s analysts.
This month, Kenya’s central bank said that it could not cut its benchmark rate from its current level of 13 per cent because global rates might still entice investor cash away from the country.
“We have to be very cautious that we don’t take measures here that will cause the same kind of problems that we had . . . whereby we again see capital flowing out because returns are lower than abroad,” Kamau Thugge, the bank’s governor, said.
However, some investors argue that, even if US rates do stay elevated, local currency bonds and the yields they offer are still more attractive than these countries’ dollar-denominated debt.
While there is still some value to be found in dollar debt, “valuations are reasonably tight,” said Daniel Wood, an emerging markets debt portfolio manager at William Blair Investment Management. “In local currency, this is more the start of the story.”
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