With long term government bonds in Europe and the US seemingly remaining low for the comings medium term, are investors better off investing in local currency bonds in emerging markets?
Of course the main question is if the yield spreads between emerging markets and emerged markets will offset the present currency risk. Looking at the charts we see that there are considerable differences between the yields of emerging countries (charts 1 and 2), as well as between Europe and the United States (graph 3).
So when investing in local-currency bonds, it is necessary to know if the yield spread over the OECD countries covers the actual extra risk.
Looking at the historic performance of the emerging markets vs. US and German bonds we might come to some early conclusions. Naturally, we have to correct for currency fluctuations to get an unbiased picture. In the table below, the emerging markets as a whole can be compared with those of the US and Germany.
In order for the current yield spread to be profitable, the future depreciation (currency risk) of emerging market currencies should not cancel out this spread.
Most of this currency risk in these markets is due to external deficits, caused by a stagnation of the manufacturing production, leading to diminishing foreign capital flows and a collapsing currency. Taking these conditions into account, Mexico and Poland, which of course have no currency risk for euro based investors, seem to pop up as countries with higher yields and minimal currency risks, as can be seen from the graphs below. With respectively increasing manufacturing (graph 5,6), decent trade balances (graph 7,8) and current accounts (graph 9,10) for these two countries.
Therefore investing in these local-currency bonds seems to offer higher yields compared to German and US bonds against acceptable extra risks.
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Gelein has been interested in the financial world and global economics since high school. For over 3 years he has been a member of a university investment team, of which one year he was the treasurer.