Chart of the week: 9 November 2018

For the first time since the financial crisis, hard-currency-denominated bonds are trading at higher yields compared to their
local-currency counterparts

The significance of the U.S. midterm elections for financial markets is hard to overstate. This is evident from the strong short-term boost we have already seen in U.S. equities, despite some rather less benign longer-term implications. For now, though, there has been plenty of relief in capital markets after the election results came in. Emerging markets provide an interesting example for the reasons why. In recent months, investors in emerging markets have become increasingly concerned about a stronger U.S. dollar or stronger increases in U.S. interest rates. Such concerns were somewhat alleviated, now that Donald Trump will no longer easily be able to put together large, deficit-financed economic-stimulus packages without seeking bipartisan compromises first. (see CIO Flash - The midterm verdict is in ) Such political bargaining takes time, at the very least. This should reduce U.S. debt issuance and perhaps ease pressures on the U.S. Federal Reserve in quickly raising interest rates.

All this makes it worthwhile to take a closer look at emerging-market bonds. Investments in emerging-market fixed-income securities come in various forms. On the one hand, there is the choice of issuer. Besides sovereign bonds, there are securities issued by private-sector entities, usually from emerging-market corporates. On the other hand, there is the choice of currency: Often, the same issuers issue bonds in both domestic and foreign currencies. So, this offers the choice between bonds denominated in external currency, typically the likes of the dollar or euro (often also referred to as "hard" currency); alternatively, there are bonds issued in local currency, like the Indonesian rupiah or Turkish lira.

Usually, bonds in local currency offer higher yields. This partly reflects inflation rates, which tend to be higher in emerging economies. So, all else equal, a local-currency bond needs to offer a higher nominal yield simply to retain the purchasing power of the money invested. Looking at data from the International Monetary Fund , consumer-price inflation currently runs at about 5%, on average, in emerging-market countries. By contrast, it is expected to come in at slightly below 2% in advanced economies this year. In addition, higher yields in local currency should compensate investors for the exchange-rate risk. Historical return volatility is significantly higher for local-currency bond indices than for external-debt indices. Developments in 2018, such as the sharp swings in the value of the Turkish lira, have plenty of reminders of exchange-rate risks. On top of that, it's often more difficult to gain access to local markets, while buying a bond denominated in dollars on a regulated market in one of the world's financial centers. Technically, it is as easy as to buy an emerging-market hard-currency bond as it is to buy, say, a European corporate bond. All these factors explain why there's usually a yield pickup in local-currency bonds.

Currently, however, this relationship has changed. For the first time since the financial crisis, hard-currency-denominated bonds are trading at higher yields than their local-currency counterparts, as our "Chart of the Week" shows. One reason for such a reversed relationship can be investors questioning a country's ability to service its external debt, while local debt can always be repaid since necessary money can simply be printed. Nicolas Schlotthauer, head of EM sovereign bonds at DWS, adds: "Over the course of 2018, investors have attached an ever increasing risk premium to external debt. In various cases, this does not match our constructive economic outlook for a number of EM sovereign issuers."