Many investors in emerging markets want a portfolio that blends “hard currency” (US dollar–denominated) and local-currency emerging-market debt. Typically, the benchmark is a 50/50 mix. But is that really the ideal blend?
Current Blends Versus the Investable Universe
Let’s start by looking at the investable universe of the leading emerging-market (EM dollar-denominated or “hard currency”) benchmark, the J.P. Morgan EMBI Global Diversified Index. Its total market cap is approximately $362 billion. On the other hand, the leading EM local-currency benchmark, the J.P. Morgan Global Bond Index—EM Global Diversified Index, is nearly triple that size, at $941 billion.
Using those proportions, a benchmark that truly reflects the composition of the EM debt sovereign universe would have 28% hard currency and 72% local currency as a baseline mix. That’s far from 50/50. The market capitalization–based ratio is an important factor in determining the optimal blend, but it’s not the only factor.
Demystifying EM Blends: To Hedge or Not to Hedge
What if we approach the question from the standpoint of finding the hard-currency/local-currency EM debt mix that achieves the highest return per unit of risk? From this perspective, 50/50 isn’t the best combination either. The best mix depends more on whether the local-currency portion is hedged or unhedged.
In the left-hand display below, optimizing the mix using unhedged local-currency debt argues for a 100% allocation to hard-currency debt with no allocation to unhedged local-currency debt. The risk/return trade-off has historically been much more favorable for hard currency than for unhedged local currency. But the perspective changes if we hedge the local-currency debt.
When currency risk is eliminated—using local-currency EM debt on a hedged basis—we get a flip result, almost like looking in a mirror. The optimal benchmark favors nearly all local-currency debt, as long as it’s hedged. At its optimal point, the mix is 20% hard-currency EM debt and 80% hedged local-currency EM debt. Not 50/50. Not unhedged.
In our view, bond and currency decisions should be separate. Sometimes a bond may be a good investment, but its currency isn’t. Some investors have lost money because they’ve left their local-currency debt exposure unhedged, which forces them to assume all of the currency risk. On the other hand, sometimes currency makes sense. But the numbers show that the best starting point is with hedging the local-currency portion.
Flexibility Is Key
Adhering to a strict 50/50 blended EM debt benchmark is simple and straightforward. We also think it’s wrong. That approach may compromise longer-term investment objectives if the benchmark restricts the investment approach and pursuit of opportunities.
In our view, success is more likely when a manager has flexibility in dealing with the most volatile component of local-currency debt: the currency exposure. There should be broad discretion to hedge local currency, which can eliminate specific currency risk that has too steep a downside. Within an EM debt blended index, we believe that currency exposure should be its own decision—with its own analysis.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.