Emerging Market Local Currency Bond Market, Too Risky to Invest?

Over the last decade emerging market (EM) sovereign debt has become a firmly established strategic asset class. Besides Dollar-denominated debt, local currency emerging market debt has also been developing to become an attractive and complementary investment asset class. EM countries have been successful to reduce currency mismatches and maturity problems by implementing sound fiscal and monetary policies. Analyzing the period from 2002 to July 2009, we show that the local currency debt provides significant additional alpha and diversification to traditional bond portfolios. In particular, first, EM local currency bond returns are less correlated to the US stock market, treasury and high-yield bond markets, and global risk premia compared to the a case of EM equity and Dollar-denominated bond markets. Second, we document that yields and excess returns on local currency debt depend largely on expected depreciation of the exchange rate against Dollar, while excess returns on Dollar-denominated EM debt are for the most part compensation for bearing the global risk. Third, we report that EM sovereign local currency bond returns beat other emerging market and mature market asset classes by providing higher risk adjusted excess returns and diversification. We believe that our results will have important policy implications not only for international investors but also for the EM governments. We suggest that the development of local currency bond markets in EM countries could contribute to global financial stability by reducing currency mismatches and reliance on foreign currency debt, which in turn is linked to growth and poverty reduction.