Emerging market bonds undervalued, says Crédit Agricole

Yields on domestic currency sovereign bonds do not accurately reflect the prospects for growth in emerging markets over the next decade, say analysts at Crédit Agricole Corporate and Investment Bank.

Instead, bond yields are being influenced by the “weight of history”.

Speaking at a media briefing on April 13, asset allocation analyst Jean-François Perrin said local currency bonds from the larger emerging market sovereigns represent significantly better value than their US dollar equivalents.

“Yields have kept decreasing on dollar bonds from the emerging markets, and they’re unlikely to rise,” he said. “Emerging market bonds issued in the local currency, however, are more attractive.”

He pointed to Brazil, where there is a large disparity between yields on sovereign bonds in dollars and those in the local currency, the real. The 12.7% yield on the 10-year local currency bond is higher than the comparable US denominated bond, which is yielding 5.9%. The gap, nearly 7%, represents a historical high.

Higher yields on local currency bonds compensate investors for factors such as foreign exchange risk and lower liquidity. But, according to Crédit Agricole’s projections, the Brazilian real, and other BRIC currencies (Russia, India and China), will stay strong compared with the US dollar over the next decade, meaning the high yields on domestic currency bonds are unwarranted.

“When you look at the data from the last decade, BRIC currencies are at the same levels they were a decade ago. They behaved well against the dollar, and we expect that to continue. So you don’t have to apply this huge discount to emerging bonds in local currencies,” Perrin said.

Hervé Goulletquer, head of fixed income markets research, called the high yields "peculiar", and argued that they reflect unfounded fears over the volatility of local currencies in the emerging markets.

“If you look at emerging market bonds in local currency you see the weight of history. As an investor you have to look forward. It’s peculiar: the current price tells us more about history than it does about the future. It is not well balanced, and we have to take advantage of this peculiar environment.”

Goulletquer argued that, by re-allocating assets toward emerging market local currency bonds, it “could be possible to extract more value without taking more risk.” He added more investors should look to the emerging markets in the long term if they are to generate alpha.

“The message we want to send is that, taking the longer view, [investor] behaviour will have to change, to take into account the structural changes in the global environment. It is our view that there will be stronger growth in the emerging markets than in the developed world. Growth plus good macroeconomic policy, that’s the bet we make. We’re not optimistic on that, we’re confident,” said Goulletquer.

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