BREAKINGVIEWS - Emerging-market bonanza gives home team advantage

Sat Oct 30, 2010 2:10pm IST

A bank employee counts U.S. hundred dollar bills at Kasikornbank in Bangkok in this January 21, 2010 file photo. REUTERS/Sukree Sukplang/Files

A bank employee counts U.S. hundred dollar bills at Kasikornbank in Bangkok in this January 21, 2010 file photo.

Credit: Reuters/Sukree Sukplang/Files

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-- The author is a Reuters Breakingviews columnist. The opinions expressed are her own --

By Agnes T. Crane

NEW YORK (Reuters Breakingviews) - Investors desperate for yield and protection against a sagging dollar are flocking to bonds denominated in emerging market currencies. Some appear to be overlooking one important aspect amid the frenzy. If things go bad, local sheriffs playing by different rules will lay down the law.

Easy money may not be leaving investors with much choice. The world has been awash in liquidity thanks to low interest rates in the developed world since the financial crisis. And the Federal Reserve is about to give asset prices a boost with another round of quantitative easing. Yields in the developed world are already incredibly low, but so are those in dollar-denominated emerging market debt, the ones most accessible to international investors.

That has left many ogling local currency debt. Not surprising. These bonds, which make up the bulk of bonds in emerging markets, can offer yields north of 10 percent while providing a hedge against the dollar's diminishing fortunes.

So far this year, investors have poured $22.6 billion into local currency funds, more than four times the amount in 2007, the last boom year, according to fund tracker EPFR. And there's much where that came from. The world's biggest investors have some $71 trillion under management. So even if they shifted their allocation just a little, it could easily drive yields down.

For now, they may still look enticing compared to what else is available. They can be more difficult to purchase depending on a country's rules on foreign ownership. Moreover, most are also ruled by local laws rather than more established financial-center jurisdictions such as New York and London.

Emerging economies can boast of savings and growth. But full implementation of the rule of law is something else altogether. Corruption is still rampant in investor-darling nations like Brazil, India and Indonesia, according to a survey released this week. That means disagreements or defaults may not be as smoothly handled as western investors are typically accustomed to.

They may feel they're being adequately compensated for the exposure. But if a wall of easy money keeps lapping up on foreign shores, the risk premium may be washed away.

CONTEXT NEWS

-- Flows into emerging market bond funds are running more than four times higher than 2005, the previous best year. This year through September, local currency emerging market funds have taken in $22.6 billion, according to fund tracker EPFR. Overall, investors have poured a total of $41.7 billion into emerging market bond funds so far this year.

-- Yields in local currency bonds are much higher than those dominated in dollars. A Brazilian fixed rate bond due in 2017, for example, yields around 12 percent. Even with the 6 percent capital control levy, an investor would still earn more than 10 percent if he held it to maturity. A dollar-denominated bond maturing in 2015 yields just 2 percent.

-- The size of the emerging market fixed income market is roughly $9 trillion with the local currency market accounting the vast majority of the total. According to Barclays Capital, global pension funds, mutual funds and insurance funds could have $14.3 trillion to invest if they decided to diversify 20 percent of their portfolios into emerging markets.

-- Transparency International in a recent report noted nearly three-quarters of 178 countries in its corruption index scored below 5 on a scale of 0 (highly corrupt) to 10 (very clean). Though some countries in the advanced world scored very low -- notably Italy -- developing countries made up the vast majority of nations with serious corruption problems.

-- Transparency International link: link.reuters.com/kyf32q

(Editing by Jeffrey Goldfarb and Emily Plucinak)

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