Last year was a stellar one for emerging market bonds. But many investors, wary of the developing world’s often volatile currencies, largely eschewed local bonds in preference for those denominated in “hard currencies”, such as the US dollar.

As a result, hard currency bonds significantly outperformed local currency debts last year. JPMorgan’s GBI-EM Broad index of local bonds returned 10.9 per cent in unhedged, US dollar terms in 2013, while the hard currency EMBI Global Diversified handed investors 18.5 per cent.

This year the roles may be reversed. Many investors and strategists argue that hard currency bonds – largely denominated in US dollars – will struggle to replicate the blockbuster performance of last year.

“Even mathematically, hard currency EM bonds cannot replicate the returns of last year,” says Nicholas Gartside, chief investment officer for international fixed income at JPMorgan Asset Management. “The opportunities are now in local currencies.”

Some money managers and analysts have even begun to fret that the dollar EM bond market is starting to look frothy – perhaps even like a bubble – as investors scramble to buy any bonds for sale.

Mongolia is a case in point. The Asian country is rich in natural resources but is a frequent ward of the International Monetary Fund, having been rescued several times in the past two decades.

Nonetheless, Mongolia sold $1.5bn of bonds late last year, equal to almost one-fifth of the country’s economic output. Investors placed orders of about $15bn – equal to twice the size of Mongolia’s economy.

“There are some signs of froth,” says Francesc Balcells, a portfolio manager at Pimco. “The technicals have been very positive for hard currency bonds.”

The biggest danger to dollar denominated EM debt is arguably rising US Treasury yields, which are the pricing benchmark for dollar bonds. Higher US yields would therefore erode the value of the bonds. Ominously, Treasuries have had a poor start to the year.

The mini-deal that allowed the US to swerve away from the fiscal cliff eased haven demand for Treasuries. But what truly unsettled the market were unexpectedly hawkish minutes from the US Federal Reserve. These cast some doubts over how long the central bank will continue with its quantitative-easing programme of buying US government and mortgage debt.

So far the rise in Treasury yields has been moderate. Few fund managers expect a dramatic sell-off. But some are nonetheless paring back their positions in hard currency bonds in favour of local debt.

“Given how far spreads have come in, whatever happens with US yields will have a big impact on hard currency bonds,” says Mary-Therese Barton, a senior investment manager at Pictet Asset Management.

After a weak 2012, flows into local currency funds tracked by EPFR Global finally began to pick up in the last three months and have lately eclipsed those into hard currency funds. Local currency bonds have already rewarded investors with small gains this year, while investors in hard currency debt have lost money.

“I don’t think the Fed is going to take away the punch bowl any time soon, but eventually it will,” says John Peta, co-head of emerging market debt at Threadneedle.

“Spreads will probably go even tighter, but ultimately there’s more potential in local currency.”

In addition to the higher yields offered by local bonds, domestic EM debt also presents the prospect of currency appreciation in 2013 – if the fundamental strength of many emerging economies manages to shine through once more.

Currency strategists at HSBC think the glass is “half full” for Asian emerging market currencies this year, arguing that the Korean won, the Thai baht and the Philippine peso in particular should outperform.

The Mexican peso remains hugely popular with currency investors, with net longs held by traders close to a record high, as measured by the US Commodity Futures Trading Commission.

HSBC’s strategists predict that local currency EM bonds will gain 6-7 per cent this year, with an additional 1-2 per cent rise from currency appreciation. But some investors expect even higher returns on the currency side. “I think FX will dominate returns in 2013,” Mr Gartside predicts. “Many of these currencies have been thwarted by big macro events, like the eurozone crisis and the US budget shenanigans, but the tail risks are easing.”

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