Local Currency EM Bonds Face The Fiscal Cliff

The dreaded fiscal cliff, should it come to pass, could have an adverse impact on myriad asset classes. From dividend stocks to high-yield bonds to select commodities, riskier assets of all stripes could come under pressure if U.S. policymakers cannot avert the GDP-draining fiscal cliff.

One of investors' favored asset classes of 2012, emerging markets denominated in local currencies, could feel a pinch, too. However, in the eyes of one portfolio manager, any damage induced by the fiscal cliff on emerging market bonds may not be severe as some are predicting.

In years past, capital allocated to emerging markets was viewed as so-called "hot" money, meaning investors viewed developing markets debt as a trade, not an investment. That situation has abated in 2012.

"EM local currency bonds are becoming more strategic, as opposed to purely tactical, allocation for many investors," said Market Vectors Portfolio Manager Fran Rodilosso. "We believe the market is supported by, in addition to the underlying fundamentals, improved liquidity, expanding yield curves, and a greater opportunity to diversify. In other words, the money that has flowed in this year might not be as hot' as in previous years."

Supportive Data Inflow data supports Rodilosso's assertion about flows to local currency bond funds being stickier this year than in previous years. One prime example comes by way of the Market Vectors Emerging Markets Local Currency Bond ETF (NYSE:EMLC), which Rodilosso manages.

In late November, Market Vectors announced EMLC had topped $1 billion in assets under management. The fund enters trading today with with over $1.16 billion in AUM, but back on May 7, EMLC had "just" $743 million in assets.

Rodilosso does admit that not all the hot money is out of the market.

"We witnessed underperformance of EM local debt in 2011, due in part to outflows on a flight-to- quality trade, so that type of hot money is still indeed there," he said in a statement issued by Market Vectors."But the progression towards more permanent allocations and, ultimately, lower volatility still appear to be in place."

EMLC's rivals are gaining assets as well. The iShares Emerging Markets Local Currency Bond Fund (NYSE:LEMB) has seen its AUM total spike to almost $367 million from $150 million in just a few weeks. The WisdomTree Emerging Markets Local Debt Fund (NYSE:ELD), the first actively managed ETF to top $1 billion in AUM, has added over 25 percent to its asset total this year.

Post Cliff If the fiscal cliff does arrive, local currency EM bond ETFs could be hit on the perception that these funds represent a risky asset class. Along those lines, it should be noted that over 60 percent of EMLC's lineup is rated investment-grade. Nearly 80 percent of ELD's constituents carry investment-grade ratings.

Rodilosso said a significant drop in U.S. growth could hamper EM country fundamentals, but he also notes the appetite for local currency EM bonds among institutional investors is growing.

That is not surprising given that investors still want yield. The spread between 10-year U.S. Treasuries and the equivalent Mexican sovereign issue is currently over 380 basis points. For 10-year Treasuries and the comparable Brazilian bond, the spread jumps to 760 basis points. Brazilian and Mexican bonds are among the top holdings in ELD, EMLC and LEMB.

Rodilosso also noted renewed interest in the dim sum bond market, an asset class that many investors passed over through the first three quarters of this year.

"The consensus seems to be forming that further yuan appreciation over the medium-term can amplify higher rates that most of these entities will pay via U.S. dollar- or Euro-denominated issues."

Investors looking for exposure to dim sum bonds can use either the Market Vectors Renminbi Bond ETF (NYSE:CHLC) or the PowerShares Chinese Yuan Dim Sum Bond Portfolio (NYSE:DSUM). Those funds have effective durations of 1.91 and 2.78 years, respectively.

For more on emerging markets bond ETFs, click here.