# **4. Sources and likely persistence of foreign investor demand**

The growing popularity of EM local currency debt is no mystery when its strong performance versus other major asset classes in recent years is considered (Figure 5).<sup>6</sup> Indeed, the basic long-term investment case for EM local currency debt—exposure to relatively high real yields, prospects for currency gains (more on this immediately below), and capital allocation to sounder sovereign balance sheets than those of many advanced economies—has not only weathered the crises of recent years, but arguably been strengthened by them.

From a multi-asset perspective, some allocation to EM local currency debt of course also confers portfolio diversification benefits. This holds even though, as a “risky asset”, the correlation of benchmark GBI-EM index returns to those of other asset classes has tended to be quite high (Figure 6). Inspecting historical correlations also reveals the close link between GBI-EM returns and EM currency returns (proxied using the JP Morgan ELMI+ index – an EM currency return index). Gaining exposure to EM currencies, which have shown secular appreciation trends, has likely been a major motivation for investors’ increased allocations to these countries’ domestic bonds.

But who exactly are these investors? Unfortunately, there are no comprehensive data on the current composition of the foreign investor base for EM local currency debt, nor is it straightforward to gauge its potential future size. However, some recent estimates are available from market participants.

**Figure 5** : **Risk, return and Sharpe ratios (2002-12)**<sup>**v**</sup>

<!-- Start of picture text --> 0% 50% 100% 150% 200%<br>MSCI-EM<br>2.00<br>Gold<br>1.97<br>Commod.<br>1.63<br>GBI-EM<br>1.28<br>EMBI<br>0.93<br>MSCI-AW<br>0.84<br>US HY<br>0.81<br>S&P500 0.74 Avg. annualized<br>ELMI+ monthly return<br>0.58<br>GBI-DM Annualized std.<br>0.54 deviation<br>US HG<br>0.36<br>Sharpe ratio<br>UST<br>Source: Calculations based on data from JP Morgan<br>Figure 6 : Correlation of annualized monthly returns,<br>Feb 2002-12<br>GBI-<br>EM<br>GBI-EM 1.00 GBI-DM<br>GBI-DM 0.50 1.00 EMBI<br>EMBI 0.65 0.41 1.00 UST<br>UST -0.01 0.61 0.19 1.00 US HG<br>US HG 0.40 0.61 0.66 0.58 1.00 US HY<br>US HY 0.52 0.09 0.63 -0.28 0.45 1.00 ELMI+<br>ELMI+ 0.91 0.49 0.61 -0.08 0.31 0.52 1.00 MSCI-AW<br>MSCI-AW 0.74 0.24 0.67 -0.23 0.30 0.64 0.75 1.00 MSCI-EM<br>MSCI-EM 0.69 0.16 0.55 -0.21 0.22 0.56 0.71 0.87 1.00 S&P500<br>S&P500 0.68 0.17 0.64 -0.20 0.26 0.57 0.67 0.97 0.81 1.00 Gold<br>Gold 0.32 0.39 0.22 0.14 0.21 0.02 0.27 0.18 0.20 0.13 1.00 Commod.<br>Commod. 0.33 0.17 0.18 -0.20 0.05 0.25 0.47 0.39 0.49 0.29 0.32 1.00<br><!-- End of picture text -->

**Source: Calculations based on data from JP Morgan**

The value of the assets under management (AUM) benchmarked to JP Morgan’s local currency EM debt indices is estimated by JP Morgan to have stood at US$146.5 billion in December 2011, up from US$79.1 billion at the end of 2010.<sup>7</sup> Standard Chartered estimates that as of end-2011, the total AUM benchmarked to all dedicated local currency EM bond indices was US$175 billion.<sup>8</sup> Standard Chartered also notes, however, that a bottom-up analysis aggregating country-specific data on bond holdings leads to a much higher estimate of total foreign bond holdings – around US$310 billion for countries accounting for 90% of the market capitalization of the JP Morgan GBI-EM Global Diversified Index.<sup>9</sup> This observation goes to the heart of understanding the investor base: foreign participation in local currency EM debt markets involves many different investor types, not just EM-dedicated, benchmarked funds.

> 6 The finding that EM local currency debt has been a strong performer relative to other asset classes since at least the early 2000s is a robust one, but it should be noted that specific numbers such as those shown here are very sensitive to the time period chosen and to the inclusion of the extreme market price moves seen at the height of the financial crisis.

> 7 JP Morgan, _Emerging Markets Outlook and Strategy_ (January 2012)

> 8 Standard Chartered, _Local Markets Compendium_ (2011)

> 9 Standard Chartered, _ibid_

**7**