By ALEX FRANGOS
As western governments mire themselves in debt, emerging-market sovereign bonds are coming of age. Asia's fast-growing economies and relatively strong fiscal positions have lured in ever more foreign investors. But, at least when it comes to local currency bonds, investors should remember that they have two legs supporting their value.
One buckled in recent weeks. Many currencies fell sharply as investors fled to the dollar for safety, leaving J.P. Morgan's Government Index Emerging Markets down 10% from its peak at one stage this week. But so far the other leg—bonds' local currency yields—have not changed dramatically. Hedge away currency moves and the index fell just 1.5%, reflecting only a modest uptick in interest rates.
That bodes well for the future. Emerging nations such as Indonesia have relatively low debt, healthy banks and faster economic growth rates than the sickly developed world. And emerging nations have accumulated larger foreign currency reserves in the past three years to help fight speculative outflows, as happened in the 2008 crisis.
Then, after the dust settled, their economies were the first to rebound. More cross investment by sovereign wealth funds and Asian central bank reserve managers since then could help stability as these are not the types of investors who sell in a panic.
But, while the long-term prospects look good, there may be cheaper prices on these bonds ahead. The risk of another drop in currencies and, in some countries, a spike in yields is very real should market turmoil continue because of the euro-zone crisis. In particular, an outflow of capital could be at hand after a period in which foreign flows into these still small and illiquid markets have been massive.
Money has come into local currency emerging-market bond funds and ETFs in 25 out of the past 26 months through August, a total of $54 billion, according to EPFR Global. Since early 2009, foreign ownership of government bonds has gone from 2.6% in Thailand to near 10% recently. In Malaysia it went from 10% to 25%.
The outflows have already started in some markets. Since the start of the month, foreigners sold $2.5 billion of Indonesian government debt. The finance ministry and the central bank masked the pain by very publicly announcing they would snap up government debt. As a result, yields on 10-year government bonds actually fell to 7.3% from 7.4% on Monday, even as the rupiah lost 3% against the dollar. It's not clear such interventions could stem a more prolonged backwash of capital into dollars.
And with yields near historic lows, there's not much cushion to be had when currencies fall. It used to be that if the currency fell sharply, investors could stand pat knowing high yields would preserve their investment. But a 3.8% yield in Thailand or even 7% yield in Indonesia, because of its history of higher inflation, doesn't provide that much comfort.
An option that avoids the immediate currency risk is dollar-denominated bonds issued by these countries. The yields have risen a bit along with the market turmoil, yet the chances of default haven't changed much. Indonesia's 10-year dollar bond traded Thursday with a yield of 4.6% compared with 4% in August. It's low in the history of emerging markets, but a nice return compared with 2% for Treasuries.
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