Federal Reserve Chairman Bernanke's promise to maintain his zero interest rate policy (ZIRP) until unemployment drops below the 6.5% level has created a fresh round of anxiety for investors. Due to structural issues -- from increased productivity through technological advances to an aging demographic -- unemployment might remain above this level during not only my lifetime, but also during the lifetime of my children. Why Mr. Bernanke, who has previously cited such structural headwinds to economic growth, would now peg monetary policy to the unemployment rate is beyond me. Add to this the doubling of bond purchases to $80 billion per month, tied to an elusive 2.5% inflation rate, and we truly do have QE Infinity and ZIRP as far as the eye can see.
This leaves retiring baby boomers, pension funds, insurance annuities, and anyone seeking stable income in despair now and for the foreseeable future.
The hunt for yield has led investors overseas as evidenced by the expanding universe of foreign bond funds, especially those that are focused on emerging markets. Exchange-traded funds such as PowerShares Emerging Market Sovereign Debt
(NYSEARCA:PCY) and iShares JPMorgan USD Emerging Markets Bond
(NYSEARCA:EMB) are the two largest and most liquid with $3.2 billion and $6.1 billion of assets under management respectively. These have both performed well, delivering yields around 4.3% and showing price appreciation of 20% and 16% respectively in year-to-date 2012. But the strike against them is that they buy bonds denominated in dollars. This means that anyone who is truly trying to diversify their portfolio and get out from under the weight of Bernanke’s printing press should be looking at funds that have debt denominated in local currencies to guard against long-term depreciation in the dollar.
Think Globally, but Invest Locally.
Neil Tiwari is the portfolio manager of New Vernon Global Fixed Income Fund, which launched in March 2009 and invests in sovereign bonds denominated in the local currency. He stated that one of the main investment objectives for this fund is not only to hunt for higher yields, but also to hunt for the diversification and tailwind afforded by non-dollar-denominated securities: "Diversification is heralded, but can be tricky to achieve." Tiwari points out that during the financial crisis of 2008-2009 all asset classes, from equities to commodities and of course real estate, suffered, leaving investors discouraged and distrustful of anything outside of the US Treasury Notes, which have enjoyed a flight to safety and the big Bernanke boost.
While there is typically an increase in asset class correlation during declines, it went to an extreme during the crisis and was exacerbated by the fact that most US investors own everything in dollar denominations. Almost every bond market outside of the big three developed countries and currencies outside of safe havens of the United States (dollar), Germany (euro), and Japan (yen) suffered losses (higher yields). But if you had bought bonds from Brazil, Turkey, or India, to name a few, with denominations in real, lira, or rupee, respectively, the currency gains would have more than offset the decline in principle. Now that Bernanke, Mario Draghi, and the newly elected government in Japan have all promised to crank up the printing presses, buying bonds in a local currency looks even more attractive. New Vernon’s Turwari noted, "Developing countries such as Brazil and the original Asian Tigers all took their medicine two decades ago and now have much better balance sheets than the developed world. They also have greater growth prospects thanks to the demographics of urbanization and a younger population." While the race to debase remains in place, emerging market currencies should rise relative to the dollar over the next few years. The higher yields offered by Brazil or Turkey, while certainly due to many of the economic and potentially political challenges, are also simply remnants of a different decade when inflation conflict ran rampant.
Recognition of the power of local currency tailwind is evident in the recent growth in ETFs that focus on emerging markets bonds denominated in local currencies. Market Vectors Emerging Markets Local Currency
(NYSEARCA:EMLC) and Wisdom Tree Local Debt
(NYSEARCA:ELD) have seen inflows of 20% in 2012 and each now has in excess of $1.2 billion of assets under management. The iShares Emerging Market Local Currency Bond
(NYSEARCA:LEMB), which only launched one year ago, saw $150 million net inflow during the last week of November, a 30% increase, to bring AUM to $750 million. These funds not only deliver approximately 3% to 5% in yield, but have also enjoyed from 9% to 20% price appreciation for year-to-date 2012. These funds own government issued bonds that have an investment grade rating and the yield is simply the coupon payment.
While the currency component can add to volatility, it should provide a nice tailwind over the next few years as the developed nations try to print their way out of debt. For those looking for yield and diversification away from the dollar, these funds make sense.
No positions in stocks mentioned.
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