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By Lauréline Renaud-Chatelain, Fixed-income strategist, Wealth Management.

Local-currency EM government bonds could continue to perform as yields drop and the US dollar sags

Overall, local-currency emerging-market bonds have delivered positive returns year to data, benefiting from declining yields and the appreciation of some EM currencies. The performance of Latam sovereign bonds has been particularly strong in local currency, and even more so in USD terms. Part of Latam’s performance stems from rate cuts from elevated levels by central banks in Brazil and Chile in recent weeks. Asian central banks have been much more timid about changing restrictive policies, with the exception of China.

While falling since the beginning of the year, local-currency EM sovereign bond yields are still higher than their historical average since 2010. Given how elevated yields in Latin America are compared to their historical average (close to 10% in Colombia, Brazil and Mexico), they could continue to fall as more central banks in the region cut rates n H2 on the back of moderating inflation.

Forex movements are another factor that could continue to play in favour of EM local-currency bonds. While the weak Chinese recovery is having ripple effects on Asian economies and has led to a general depreciation of EM Asian currencies against the US dollar this year, the latter could weaken as US economic growth slows whereas EM growth proves more resilient thanks to policy easing.

Given our expectations for a stabilisation of Asian sovereign bond yields around their historic average on the one hand, and a fall in Latam ones on the other, we project the average EM local currency-yield to fall slightly from 6.4% today towards 6.0% by the end of the year, with risks tilted towards a more significant fall if central banks surprise with more rate cuts than are currently priced in.

In short, along with average yields that are comfortably above 6%, low correlation with developed market sovereign bonds this year and the prospect that EM currencies strengthen against the US dollar are all factors that could continue to benefit the performance of local-currency sovereign bonds. Hence, we have decided to move from a neutral to overweight position on these instruments as an attractive alternative to developed-market sovereign bonds.

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Author LFI

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