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* Hopes for recovery on EM currency bonds after 3 years of losses
* Some funds such bet on double-digit returns
* But many wary of US recovery boosting dollar again
By Sujata Rao
LONDON, March 4 (Reuters) - After three years of negative returns in emerging market currencies and local bonds, and at least as many false dawns, some investors are punting again on a turning point - this time hopeful of a downturn in the dominant U.S. dollar.
Dollar-based investors suffered an average 15 percent losses last year on bonds denominated in currencies such as Turkish lira and Mexican peso, and sector funds tracked by the EPFR Global consultancy witnessed $12.6 billion in capital outflows - the third straight year of losses.
But some say that even if the outlook for emerging economies is precarious, local-currency bonds are now attractive.
Already this year, emerging currency debt has returned 4 percent in dollar terms, comparable to German and U.S. government bonds but well above most other mainstream asset classes, this chart shows:
BlackRock, the world's largest asset manager, predicts domestically issued debt will deliver double-digit returns in 2016, as external headwinds start to ease.
And the main gale has been a worldwide revaluation of the U.S. dollar of more than 25 percent against major developed country currencies, with gains against many emerging currencies amounting to as much as 30-60 percent.
For investors in emerging currency bonds, that meant heavy losses in dollar terms wiped out gains on yield.
This year, as recession fears raged in January and early February and U.S. interest rate rises fell off the horizon, the dollar backed off and forecasters started to rethink. .
Like most investors, BlackRock's head of emerging fixed income, Sergio Trigo Paz, spent three years sheltering in the relative safety of emerging market bonds denominated in hard currencies such as the dollar or the euro, but he recently turned bullish on local debt for the first time in three years.
"We expect double-digit returns so...we are very overweight. The more things go our way, the more we shall add (to positions)," Trigo Paz said.
Predicting a dollar pullback, he added:
"If you talk of a one-third (dollar) retracement, we talk of 7 percent. So in emerging local debt you get to clip your coupon of 7 percent, plus another 7 pct on EM currencies if you get a dollar depreciation of 7 percent across the board."
There may also be support from steadier commodity prices, Trigo Paz argues, noting exporting nations have shown willingness to act to prevent further crude price falls.
If dollar risks are indeed neutralised, investor focus should turn again to emerging market yields. That's especially so because around $6 trillion worth of global bonds carry negative yields and interest rates in a swathe of developed countries are below zero.
Average yield premia offered by emerging local bonds over U.S., eurozone and Japanese government debt is around 5.4, 7.2 and 7.1 percentage points, according to Salman Ahmed, chief global strategist at Lombard Odier, who is advising investors to reconsider emerging markets.
The premium paid in 2012 was much lower at 4.5, 4.7 and 5.3 percentage points respectively, he estimates.
Finally, steadier currencies should allow some central banks to cut interest rates - Indonesia, India and South Korea are among those likely to soon ease policy. Russian 10-year yields have fallen 100 bps in the past month as oil prices stabilised.
But the emerging world still faces formidable challenges.
Recent business activity data showed recovery remains elusive for most economies; exports and domestic demand are sluggish and the population's hardships are hampering governments from implementing vital reforms.
There are also question marks over China, which many fear will be forced to devalue its yuan, in turn dragging down other emerging currencies.
So despite the lure of 7 percent yields, Steve Ellis, portfolio manager at Fidelity International, still prefers emerging dollar bonds, citing high currency volatility on the local debt sector.
"We've had times before when we thought it was a good time to go into emerging local currency, we thought there were green shoots but they were false dawns," Ellis said.
"You need to see the growth backdrop improving, that will give you the green light."
What's more, with the U.S. industrial sector showing signs of a bounceback and labour markets increasingly tight, Fed hikes have returned to the agenda and the dollar may yet have sting in the tail.
For the faithful, emerging currencies are undoubtedly cheap on historical comparisons - the rouble and Brazilian real for instance are 25-30 percent below their own long-term averages against trade partners' currencies and adjusted for inflation, this chart shows:
BNP Paribas Investment Partners said that despite its bearish view on the developing world's prospects, it has decided nonetheless to close its underweight position on emerging local debt, telling clients it had become "increasingly uncomfortable standing against" such cheap currencies.
Similarly, UBS Wealth Management also recently added exposure on local emerging bonds. But wary of currency risk, it is hedging the overweight with a short position in emerging money market instruments, usually short-dated t-bills.
That offers some protection from a dollar surge.
The key thing is the ability to stomach some volatility and to have a slightly long horizon says Yacov Arnopolin, portfolio manager at Goldman Sachs Asset Management.
"If you do, this is a decent entry point after three years of significantly negative returns," he said. (Graphic by Vincent Flasseur; editing by Anna Willard)