Institutional investors move into local-currency debt

Institutional investors are making big moves into emerging-markets local-currency-debt strategies, taking broad strides to catch up to allocations previously made to emerging-markets bonds denominated in U.S. dollars.

And sources said that the trend has just begun, with more pension plans and sovereign-wealth funds expected to tap the asset class for better risk-adjusted returns, diversification and exposure to fast-growing economies and currencies.

The asset class has seen explosive growth in the United States in the past two years as pension funds have expanded into stand-alone local-currency mandates or hired money management firms that blend a mix of hard- and local-currency bonds in one portfolio.

Recent examples include:

• The $48.1 billion Massachusetts Pension Reserves Investment Management Board carved out $900 million in August for local-currency debt.

• The $4.4 billion Missouri Local Government Employees Retirement System hired Stone Harbor Investment Partners LP last year to run $180 million in emerging-markets blended debt.

• The $21.4 billion Iowa Public Employees' Retirement System began a search last month for an emerging-markets-debt manager to run $350 million in a blended strategy, according to a request for proposals on its website.

• The $211 million Town of Brookline Contributory Retirement System in Massachusetts started a search in August for an emerging-markets local-currency-debt manager to run $4 million initially.

BOOMING MANDATES

According to InterSec Research LLC, a research and analytics firm, new institutional mandates for emerging-markets local-currency debt in 2010 shot to $1 billion, up from $115 million of new mandates in 2009. The latest available data show that as of June 30, U.S. institutional investors were on track to double 2010's level.

Investment consultant NEPC LLC conducted 65 emerging-markets local-currency-debt searches with a combined asset value of more than $2 billion last year, up from next to none in previous years.

At Mercer, search activity in the United States cooled last year after booming in 2010. From a base of just two searches each in emerging-markets debt and local-currency debt in 2008, local-currency searches shot to 29 in 2010 then fell last year to 15 as overall search activity subsided.

Emerging-markets-debt searches rose to 16 in 2010 before dropping to seven last year.

Although 2009 saw a pretty dramatic spike in new emerging-markets-debt allocations by U.S. institutional investors, “it was still mainly your opportunistic emerging-markets-debt strategies, and they were still primarily U.S. dollar-based,” said Brendan Cooper, head of analytics at InterSec.

“We're seeing a shift more into just pure local-currency products' being funded,” he said.

But Thomas Brock, chief executive of Stone Harbor, said: “The phenomenon is global. We're seeing the trend of increasing interest from official institutions around the world, including from sovereign-wealth funds, and those mandates can be quite large.”

In addition to Stone Harbor, big winners include Pacific Investment Management Co. LLC, Pictet Asset Management Ltd. and Wellington Management Co. LLP.

Additionally, in the United States, old favorites in hard-currency strategies — Ashmore Investment Management Ltd. and Standish Mellon Asset Management Co. LLC — are winners in local currency, as are some firms with emerging-markets-equity expertise, such as Grantham Mayo Van Otterloo & Co. LLC and Investec Asset Management.

Wellington's prodigious pipeline caused the firm to close its emerging-markets local-currency-debt strategy in late 2010, when assets were about $3.5 billion, said a source familiar with Wellington, who asked not to be identified.

By year-end 2011, assets in the strategy topped $9 billion, nearly a threefold increase.

Wellington spokeswoman Sara Lou Sherman declined to comment.

According to eVestment Alliance, Stone Harbor's assets in the strategy more than doubled last year to $12.2 billion, from $6 billion, while Pimco's rose 46.8% to $18.6 billion.

“ONCE IN A LIFETIME’

Local-currency strategies began a “once in a lifetime” phase as they became “discovered” in the United States about 18 months ago, said Alexander Kozhemiakin, managing director and head of emerging-markets debt at Standish Mellon.

“It's spreading like wildfire right now,” he said. “We're invited to finals once every other week now … We're going through a who's who of corporate plans in the U.S.”

Mr. Kozhemiakin declined to identify the plans.

Pictet has been a perennial contender for new business in emerging-markets local-currency bonds in the United States, observers said.

But globally, its emerging-markets local-currency assets fell to $8.8 billion last year, from $9.1 billion, a 3.3% drop.

“Rotations of our client base” did cause a loss in local-currency assets, said Simon Lue-Fong, director and head of emerging-markets fixed income at Pictet.

Wholesale clients, after having gotten into the asset class early, took profits last year.

That trend will be reversed by inflows from pension funds, Mr. Lue-Fong said.

He described the U.S. market as a “big, sleepy giant” that is being roused by emerging-markets local-currency debt.

In August, MassPRIM reduced its global equity allocation by 6 percentage points to 43%. Some of that was used to fund a 2% allocation to emerging-markets local-currency debt.

That complements a $700 million allocation to hard currency in place since 2004.

“We think we can get a better risk-adjusted return and lower overall portfolio risk” by moving from equities to local-currency emerging-markets bonds, said Stanley P. Mavromates, MassPRIM's chief investment officer.

MassPRIM was expected to hire Pictet to run $400 million, and Investec and Stone Harbor to run $250 million each, at a Feb. 7 meeting.

Not all the moves are being funded by equities. Indeed, a major driver comes from the breakdown of the core-plus approach to structuring a bond portfolio.

Whereas higher-risk, higher-returning asset classes such as high-yield and emerging-markets debt once were part of core-plus, they are now getting their own time in the spotlight.

“Five years ago, when I talked to U.S. investors about emerging-markets local-currency bonds, very few people were willing to listen,” Mr. Kozhemiakin said.

“Up until recently, U.S. investors have been wedded to the idea of core-plus as an investment paradigm,” and had home and equity biases, he said.

Why not just invest in emerging-markets equity?

“The answer is that at the very least, you get better risk-adjusted returns” by investing in local-currency debt instead of emerging-markets equities, Mr. Kozhemiakin said.

But not all investors go for local-currency mandates.

“We like the diversification between local-currency and external [or hard-currency] debt,” said Moustapha Abounadi, director of investment research in fixed income at Rogerscasey Inc.

Last year, it was easy to see how the two “can diverge quite substantially … [like] in the third quarter, when the sell-off in emerging-markets currencies was quite massive,” he said.

Brian Collett, CIO of the Missouri Local pension fund, said that during the manager search process, Stone Harbor executives convinced him that they could add value through allocating among hard- and local-currency sovereign debt, and local-currency corporate debt.

Drew Carter is a reporter with sister publication Pensions & Investments.