LONDON, July 12 (Reuters) - Following stellar returns in the first half of 2016, emerging currency debt is being swept up in a fresh rally re-kindled by Britain’s Brexit vote that is crushing bond yields across most developed markets.
Between January's global market rout and the end-June selloff triggered by Britain's vote to leave the European Union, bonds denominated in emerging currencies returned 15 percent in dollar terms, better than almost every other asset class this year reut.rs/24AQWD0
The half-year also saw a number of big-name funds ramp up exposure to local debt, some such as Blackrock for the first time in years. Templeton’s star fund manager Michael Hasenstab said Brazilian and Mexican bonds were among the top holdings in his $50 billion flagship fund .
Few had expected that run to be matched in the July-December period. But in fact, the momentum may be accelerating.
What the Brexit vote has done is push an additional $1 trillion or more worth of bonds from the developed world into negative-yield territory, taking the tally to over $10 trillion.
Expectations for a U.S. Federal Reserve interest rate rise have moved deep into next year, the Bank of England is likely to cut rates this week and policymakers elsewhere seem intent on dishing out more stimulus.
“This is a world looking for any country with real yields,” said Steve Ellis, portfolio manager at Fidelity Worldwide Investments.
While only 6 percent of global bonds currently offer yields above 2 percent, emerging local bonds pay an average 6.2 percent, 490 basis points above U.S. Treasuries, he said.
Ellis was wary of local debt as recently as March, citing currency swings and dire economic growth in emerging markets. But recent signs of growth stabilisation have made him more positive on the sector where he now expects yields to fall sharply.
Yields across emerging markets, from South Africa to Russia to India, tumbled to multi-year lows this week while benign inflation should allow many central banks to cut interest rates. Malaysia this week cut rates for the first time in seven years, pushing 10-year yields to 2-1/2-year lows
“Out of all the segments, the local currency bond (in terms of) duration is one of the most favourable,” Ellis said. “You could quite easily see another 100 basis points of (yield) compression versus Treasuries.”
Duration is a measure of how much bond yields may change if interest rates rise or fall.
JPMorgan said emerging market local bonds, funded in dollars, are high on the list of attractive assets to own.
Because the rally was preceded by five years of losses, valuations are still attractive, JPM’s chief market strategist Jan Loeys told clients. Yields are still above the six-year mean, he added.
Fund flow data from JPMorgan, which runs the most widely used emerging bond indexes, showed emerging bond funds received $3.3 billion last week, the largest weekly inflow since it started tracking the data in 2004.
However, net flows to local debt funds remain negative, as many have been wary of exchange rate variations.
That is still the case, given the potential for sudden dollar moves that can wreck returns overnight. Jonas David, EM FX & Rates specialist at UBS Wealth Management has only cautiously increased exposure to the local debt sector, and mainly on an currency-hedged basis.
“We have a still supportive risk environment, but it is very fragile,” David said. “When we look at the six-month horizon, we expect some weakness on EM currencies.”
Aside from Brazil and Indonesia, favoured by many investors, David said South Africa could become attractive as the currency adjustment looked “very advanced compared to emerging market peers”.
But increasingly, some investors may be forced to look past these risks.
The pension and insurance industry has been hardest hit by the collapse in developed yields putting them at greater risk of defaulting to policyholders in future.
For instance the pension deficit at companies listed on the S&P500 totalled $455 billion even before the Brexit-fuelled yield collapse, Citi analysts point out. One solution is to buy longer-dated debt but emerging debt is also an option.
“There is now an embedded need for large real money investors to extend fixed income duration in their portfolios, which may filter through to ... emerging markets as well,” Citi told clients.
Bonds from Poland, South Africa and Mexico, included in the $2 trillion WGBI global bond index, are most likely to see inflows, the bank added. (Additional reporting by Marc Jones and Sujata Rao; editing by Ralph Boulton)