For investors who want an emerging-market (EM) debt allocation that includes EM local-currency government bonds, it may make sense to use developed-market (DM) government bonds to diversify EM currency volatility.
As we’ve discussed, when it comes to EM debt, mixing unhedged local-currency bonds with hard-currency bonds (EM debt denominated in US dollars) offers only limited portfolio benefits. That’s because EM currency returns are highly correlated with changes in credit spreads—both respond positively to the “growth factor.” So currencies tend to rally and credit spreads tend to fall when EM economic growth shows signs of being relatively strong. Likewise, currencies decline and credit spreads rise when economic growth disappoints.
What’s the Best Diversifier for EM Local-Currency Debt?
Investors looking for a more efficient portfolio when combining EM local-currency debt with another fixed-income sector have to deal with this correlation problem. They can take two approaches. First, as we’ve mentioned, they can simply use currency hedging to remove EM currency risk from the local-currency portion of the portfolio.
A second approach is designed to remove the impact of the growth factor embedded in EM currencies by diversifying it away. The trick is to pair that growth-factor exposure with interest-rate exposure (as measured by duration), because those two factors tend to be negatively correlated—they move in different directions.
One way to create this growth-duration pairing is to mix unhedged EM local-currency bonds with investment-grade EM hard-currency bonds. Using investment-grade bonds reduces the amount of credit risk and hopefully maximizes the impact of the US interest-rate duration embedded in those bonds. But there are limited benefits from this approach: even though investment-grade hard-currency bonds have less credit risk than lower-quality bonds, they have enough credit risk that their correlation with EM currencies is still high (Display, left). So, there’s a fair bit of exposure to the growth factor we discussed.
Diversifying with Developed Markets
We think there’s another way to tweak the mix that does better—one with even less credit risk and a more pure form of interest-rate duration to diversify away the growth factor in EM local-currency bonds. Why not consider developed-market government bonds? It’s hard to find a purer source of interest-rate risk. As the optimization in the Display, right, suggests, when unhedged EM local-currency bonds are blended with unhedged DM government bonds, the portfolio diversification benefits are quite significant, because EM and DM are less correlated.
Based on this research, it seems that the most effective asset to pair with EM local-currency bonds in a truly global EM fixed-income approach is unhedged DM government bonds. Together, this pair appears to hold the most promise for unlocking the return potential and diversification attributes of EM local-currency debt.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
