Go east, young man – holding foreign currency, not dollars

‘Go east young man’ seems to be the mantra for bond investors these days. I can just imagine the conversations taking place between portfolio managers and their clients: “Now Mr Stevenson, we understand your worries about the fragile global recovery, and think it best to steer you towards ultra-short duration US Treasuries. Wonderful credit record – Uncle Sam has never reneged on his debts”. To which the worried client might reply: “But what happens if my ‘risk free’ holding becomes hugely risky because of a dollar run? Find me some safe Asian bonds, young man, and be quick about it!”.

I can certainly see the logic of such a currency play via Asian bonds – even if some portfolio managers can’t. It has been well articulated by academics Bela Balassa and Paul Samuelson: the trend towards faster productivity growth in developing countries must in turn raise prices in those countries as their societies grow richer (relative to other countries) and this process eventually results in a strengthening of their currencies.

Steve Johnson recently ran an excellent article in FTfm (Warning not to expect free lunch, April 1) on the Balassa-Samuelson effect and quoted one fund manager who reckoned that, since 1998, currencies have accounted for between a third and a half of UK investors’ returns from emerging market equities. Another strategist suggested that the spot price of emerging market currencies will rise by 1.7 per cent a year in the next ten years – on top of a yield pick-up, or carry, of 2 percentage points.

Obviously, there are caveats to this proposed new carry trade. All ‘sure-fire’ trades eventually unravel as more investors pile in. Previous developing country currency trades – in Argentina, pre-revolutionary Russia and China – resulted in the Black Swan of unpredictability making an appearance and ruining the party. And then there’s the never-ending ability of central bankers in places like China to frustrate the whims of the market.

Nevertheless, the idea of investing in a basket of emerging-market currencies via bonds doesn’t look like the daftest way of accessing the emerging-market growth story.

Clearly, Aberdeen Asset Management has spotted this opportunity. It runs what it claims is the UK’s first short-duration Asian bond fund, which is now available here in the UK via a Luxembourg SICAV. Compared with the 6 per cent yields on conventional emerging market debt funds, the Aberdeen fund’s running yield of just over 3 per cent is hardly competitive. But that low yield is a function of the short-duration bonds it holds, which make it potentially lower risk.

Also, Aberdeen knows a thing or two about both Asia and fixed income investing. Its data from 2005 to 2010 show that Asian short-duration bonds produced a total annual return of around 7 per cent. To put that in context, US bonds returned just under 6 per cent while emerging market debt turned in 13 per cent a year.

Now, consider the comparative risk. It is now hard to argue that US government debt is without risk or even low risk. Equally, a lot of emerging market debt is now looking a touch pricey, relative to developed world debt. I’d certainly be nervous about investing in an emerging market bond tracker fund at this late stage in the cycle.

By contrast, most Asian states look to be in fine fettle. Apart from a few exceptions, they have low levels of government debt. Their bond prices have the potential to rise as more investors opt for Asian sovereign risk over the US.

But the key feature of the Aberdeen fund is that it invests in local currency bonds – not the better-established dollar-denominated issues. Its top holdings are in Korea, Malaysia and Thailand and this specialism in local bonds requires an active approach. As a result, the fund has a total expense ratio of 1.75 per cent. By sticking to local currency bonds, however, there’s arguably better value to be had and a little more yield on offer – plus the potential for currency gains.


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