Indonesia’s inclusion into the bellwether Bloomberg Barclays Global Aggregate Index (Global Agg), and China’s pending addition, should boost overseas interest in local currency emerging market debt (EMD) but will create new challenges for bond investors. To make the most of these changes, investors will need to ensure that their EMD exposure is well managed and offers them the diversification and yield they expect from an asset class likely to benefit from improving global growth.
More inflows into local currency EMD
Indonesia and China are the latest EM bonds to join or be slated to join the Global Agg. While the total EMD exposure of the Global Agg will remain relatively small, the increase in the number of EM countries should be positive for investors in local currency EMD. More than two-thirds of the bonds in EMD indices are now available to global investors via the Global Agg. EM countries within the Global Agg on average attract 11.5% more international investors than countries not in the index. This additional demand for their bonds reduces their overall funding costs. For example, Indonesian bonds rallied hard after they were upgraded to investment grade and in anticipation of their likely addition to the Global Agg. Their ten-year yields dropped from about 8.3% at the end of December 2016 to 6.5% at the end of December 2017.
However, greater international flows also bring a higher correlation between the EM local currency universe and global fixed income assets, meaning volatility might become similar to that of other EM subsectors (e.g., USD-denominated sovereign and corporate debt).
Challenges of including Indonesia
The inclusion of Indonesia presents unique challenges for global investors. Investing in EM bonds is already more expensive than in developed markets (DMs) thanks to higher custodian charges for holding EM bonds in domestic accounts. The weighted average cost for DMs is less than 1 basis point (bp) per annum while it is roughly 10 bps for EM. Cost per trade is similarly expensive, with EM investors paying on average about USD 50 per trade versus about USD 11 in developed markets.
On top of this, Indonesia has the highest tax rate in the Global Agg. So although it enters the index as the country with the highest weighted average coupon rate, offering an attractive yield, investors need to be aware that the normal withholding tax on coupons and capital gains tax are 20%. This can be reduced to 10% if custodians are able to reclaim taxes. However, the process can be challenging and is often delayed. It could add 0.5 bps of tax charge per annum on coupon income, and possibly much higher capital gains tax (CGT) if deep-in-the-money bonds are sold. A fully replicated fund tracking the JPM GBI-EM Global Diversified (GBIEM) index and paying 20% tax in Indonesia would have paid about 16 bps of CGT in 2017 alone, accounting for as much as 40% of total CGT payments. While the impact for Global Agg investors is limited, given the small weight of Indonesia, it does highlight the increased cost of investing in the Global Agg as more countries join.
Another challenge is liquidity. Of the 50 or so Indonesian bonds being added to the Global Agg, only the four “on-the-run” benchmark bonds (i.e., those most recently issued by the government) remain the most liquid at any point, so it may be harder to buy the rest.
Finally, Indonesia is one of several countries in the Global Agg whose bonds are restricted and not freely tradeable beyond domestic boundaries. Our analysis shows that many EM asset managers are unable to trade IDR currency directly and rely on custodians for currency exchange through a standing order (known as AutoFX). Currency converted via this route is not only expensive but the execution can be delayed, increasing trading costs or gains given the volatile nature of the currency. As a result, the growing complexity of the Global Agg may result in higher tracking error for many asset managers.
State Street has a long history of investing in Indonesian local currency bonds, having launched its pioneering Asia Bond Fund in 2005. In 2017 alone, we traded around USD 1 billion in rupiah-denominated bonds, dealing directly in Indonesian rupiah (IDR) currency. Our long association with EM debt gives us a deep understanding of the nuances of EM bond and currency markets and we are well placed to benefit from these changing market dynamics.
Where next for EMD?
Following a strong 2017, in which EM corporate and sovereign hard currency debt issuance was the highest on record, EM debt markets have sold off recently on fears of US protectionism and dollar strength. Despite this and further policy normalization, the addition of EMD countries to the Global Agg should create enough demand to help sustain EM inflows over the year, perhaps even more than last year according to Institute of International Finance estimates. OPEC production cuts are expected to support oil prices – a positive for many EM countries – while yield differentials and currency valuations may be less attractive than before but still offer value. Some EM central banks are becoming more hawkish while others are still cutting rates, so we expect a more mixed monetary policy picture, though still broadly accommodative.
The Global Agg has come a long way from its developed markets roots. While a broader global bond index should be helpful for EMD investors over the short to medium term, it may in time lead to crowding out in local EMD markets. If this happens, investors will need to look beyond the currently indexed EM countries to find yields that match the levels of risk they are taking. Moreover, while the inclusion of more EM countries in the Global Agg strengthens diversity and may raise the total yield, it also brings greater complexity and other challenges that could increase costs. In such an environment, investors should consider the benefits of working with managers with a deep understanding of local markets and their idiosyncrasies.
Bloomberg Barclays Global Aggregate Index: A benchmark designed to provide a broad-based measure of the global investment-grade fixed income markets. It has three major components: the US Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. It also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment-grade 144A securities.
JPM GBIEM Index: A comprehensive emerging market debt benchmark that tracks local currency bonds issued by emerging market governments.
The views expressed in this material are the views of Abhishek Kumar through the period ended May 8, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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