* Local currency bonds lose appeal
* Dollar strength battering EM FX
* Asia a rare bright spot
By Sudip Roy, Michael Turner and Daniel Stanton
LONDON, July 30 (IFR) - Leading fund managers are questioning the merits of investing in large pockets of emerging market local currency bonds, after years of poor returns look set to worsen with no reprieve expected for at least another 18 months.
A combination of looming US interest rate hikes, sliding commodity prices and jaded growth prospects are heaping pressure on the asset class.
Investors are becoming increasingly wary as renewed currency wobbles have helped depress returns further.
"Increasingly, local currency is not seen as a pure standalone investment," said Zsolt Papp, global head of emerging market debt client portfolio strategies at JP Morgan Asset Management.
JP Morgan's GBI-EM Global Diversified, which measures the performance of local currency bonds, is down 7.4% for the year up to July 28 in US dollar terms.
By contrast, the EMBI Global Diversified, which tracks emerging markets sovereign hard currency bonds, is up 1.4% over the same period, while CEMBI Broad Diversified, which measures emerging markets corporate hard currency debt, has returned 3.5%.
The poor performance of the local currency index is not isolated to this year. Investors have earned a return of just 5.41% through the GBI-EM index since January 1 2010. The EMBI Global is up 45.6% over the same period, while the CEMBI Broad has delivered a total return of 43.26%.
"A simple EM FX appreciation strategy has not been valid for the past five years," said Papp.
Emerging market foreign exchange, and by extension local currency bonds, have taken a hammering from the money-printing efforts of developed market central banks, according to Jan Dehn, head of research at Ashmore.
"There have been trillions of dollars created that are exclusively being used to buy developed market assets," said Dehn. "Not a single QE has bought emerging market assets."
Emerging market currencies are scraping along at multi-year lows, with the Turkish lira the weakest it has been against the dollar in 20 years at 2.7669 on Thursday morning, according to Thomson Reuters Eikon prices.
The Brazilian Real is at BRL3.3283 to the dollar, a 12-year low, while the Russian rouble, at RUB59 on Thursday, is 53% weaker than it was 10 years ago.
But with US growth for 2015 predicted by the IMF at 2.5%, inflation is expected in the world's biggest country by GDP, and with that, rate rises from the Fed.
Both will weaken the dollar and encourage money back towards unloved emerging market local currency-denominated debt.
"A rate hike will stop the hyper-volatility and uncertainty around the timing of the hike," said Dehn. "It will be positive for credit, including emerging markets."
Inflation is expected to pick up in the US at the tail-end of 2016.
"On that metric, we should be on the back foot in emerging market currencies for another year and a half," said Dehn. "I do not imagine that lots of investors are going to take an outright position on EM FX - we haven't - but there is an argument for cautiously going into local currency bonds."
It is not all bad news for soft currency debt. Investors in Asian local currency bonds, which tend to benchmark against the weak euro, have done better than their Central and Eastern Europe, Middle East and Africa and Latin America-focused peers.
"This year, Asian local currency markets are very slightly down, but still outperforming the G10 and broader emerging markets," said Kenneth Akintewe, senior investment manager on Aberdeen Asset Management's Asian fixed income team.
Asian currency volatility moves on average in a range of about 8%; within that the yuan is around 2% and the ringgit above 10%. In the broader emerging markets like Latam, currency volatility can be 15%-20%.
"Despite the volatility in equity markets, China's bonds and currency will likely continue to outperform the broader EM markets as sentiment remains fragile and volatility high, providing one of the better allocations," said Akintewe. (Reporting by Sudip Roy; Michael Turner; Daniel Stanton; Editing by Philip Wright; Julian Baker)