HARD VERSUS LOCAL CURRENCY
What is the difference between hard currency and local currency? There are a few ways of answering that question. The most basic difference is that in local currency the risk of actual default is not the primary concern. It is conceivable that countries can default in local currency, but the real risk is that they pay you back in a currency worth a lot less. In hard currency, a sovereign borrower cannot print dollars. They have to work hard to get those dollars. Therefore, there is actually a risk of default in those bonds. But if you pick your countries properly, the risk of default should be low, in my opinion.
Currently, in hard currency, it is hard for me to find a lot of value. I think spreads are low because hard currency bonds are simpler for most investors to understand and invest in. In a risk-on environment, which I think we are continuing to have, I see much more value in local currency. A final point I would make is that if we do have a risk-off period – whether for a day, a week, a month, or a quarter – one could make the case that the most basic manifestation of risk-off is buying U.S. dollars. When investors sell risky assets, the global plumbing is such that the U.S. dollar is still the global reserve currency, so they tend to buy dollars. This would put more downward pressure on local currency than on hard currency, in theory. Of course, I am making a blanket statement, but there are nuances, and things change over time. Those are, I would say, the biggest distinctions between hard currency and local currency risk.
A BIAS TOWARD LOCAL CURRENCY
Just because you like emerging markets does not mean you should be forced to buy hard currency debt, which has been the traditional way of accessing the market. Right now, Brazil’s five-year credit default swap (CDS) level is about 100 basis points over Treasuries. I was just in Brazil and I think there are some problems with the policy mix. Brazil’s institutions generally have respect for the authorities, but I think they are a bit confused right now. They are trying to figure out what policy will be, but the situation is clouded by a lot of corporate issuance in Brazil.
If, for whatever reason, there is a risk-off moment, and the exit from these corporate bonds begins, then the situation could change. I’m not predicting this will happen, and it probably won’t. But if it did, bond prices would gap, and investors would buy five-year Brazil CDS as credit protection, in my opinion. It is still relatively cheap at only 100 basis points over Treasuries. By definition, the market can only rally by a 100 basis points, but it could sell off by a lot more, and I can point to other similar examples. We are seeing a large number of emerging market hard currency credit spreads that are in this 100-over area, which by definition does not create much upside for the bond buyer. I think this is another advantage of an unconstrained approach, meaning we do not have to be in any given currency if we do not see value, and we do not have to be in every local currency market just because we think the global plumbing is going to support local currency markets. We can be selective.
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