Saturday, 19 September 2020

EMLC: Bet On EM Currency Appreciation With This 6.5% Yielding Fund

- While gold and bitcoin offer a hedge against the U.S dollar, they don't deliver a yield. EMLC offers both the hedge and a 6.5% yield.

- With the U.S dollar signaling a peak soon, it may be the most opportune time to load up on dollar hedged assets like E.M currency bonds.

- E.M currencies have much higher rates than those in the developed world and, a few years of difficulty, look to be out of the woods soon.

- The Vaneck E.M local currency sovereign bond fund may be one of the most profitable low-risk ways to bet on a lower U.S dollar.

- U.S rate differentials are on the decline, the U.S dollar is likely to follow suite.

Over the past few weeks, I've been taking a deep dive into emerging market currencies. In "A Closer Look at Emerging Market Currency Instability" I detailed the driving factors behind the ongoing weakness in currency markets. Chiefly, excessive buildup U.S dollar and developed world denominated debt In E.M's that has created a global currency shortage and has spiked inflation in developing countries.

While this factor has caused a multi-year deterioration and has catalyzed the collapse of a few currencies, it looks to be ending shortly. I am still bullish on the U.S dollar, but I have taken profits on a significant portion of my position and am beginning to look for U.S dollar short investments. In "CEW: Look to EM Currencies for Dollar Hedged Real Yields", I explained how the E.M currency ETF (CEW) can deliver hedged value similar to gold, but with a nice yield around or over 2%.

If you're looking for the same hedged low correlation exposure but a higher yield, the VanEck Emerging Markets Local Currency Bond ETF (EMLC) may be a good option. The fund invests in local currency priced sovereign bonds in E.M's around the world (excluding China) and pays a very high yield of 6.5% after expenses.

Frankly, (EMLC) may be the only historically cheap bond fund I see on the markets today. Even more, it does not hold the high U.S inflation and interest rate risk than most far lower-yielding bonds. It is, of course, more volatile and, if the U.S dollar continues to rise, will continue to fall, but the fact that the fund has kept its level despite dollar strength this year signals the bottom may be in.

The VanEck E.M Local Currency ETF

Before we get into the macroeconomic trends facing the fund, let's go over the basics. The ETF was launched in 2010 and did not see high inflows until recently when its yield became very attractive compared to market norms.

The fund currently has great liquidity with nearly $5B in AUM which has risen substantially since the E.M currency selloff in 2015 (which coincided with a boost in yields). Importantly, the fund has delivered little in total returns thus far. As a contrarian investor, this is often a good thing because it means investor expectations are generally low.

The yield on the fund is at a historical peak even though the 20-year treasury (and frankly all treasury and developed world rates) are at a minimum yield.

The trick with bonds is very simple, buy when yields are at historic highs and sell when they're at historical lows. When yields are high, not only do you get higher returns but also you get lower interest rate risk. On the contrary, when they're low you get both low returns and high-interest rate risk. Of course, yields do not always mean revert, but they do so much more often than do stocks.

EMLC Holdings and Exposure

The fund is heavily diversified between countries and relatively diversified across maturities and credit qualities. All of its holdings are in sovereign government local currency bonds so it does have higher exposure to the U.S dollar. Importantly, this is not necessarily exposed to the "U.S dollar index" because that is based on developed world currencies, not those of E.M's.

The fund is exposed to all regions of the globe but does have higher exposure to Brazil and Mexico. While I do not see it as a substantial material risk to the fund, I do think the Brazilian Real may have some weakness in front of it. That said, I am very bullish on the Mexican peso.

Overall, most of these countries recently experienced an inflationary shock and have since raised interest rates above inflation to stop the bleeding. This is most extreme in Argentina which has a staggering 55% inflation rate, but an even more staggering 72% interest rate (depending on where you get it from).

While currency risk is the main risk to the fund, I frankly see the possibility of appreciation against the U.S dollar as the more likely scenario which would add to principal returns without harming yields.

Other than currency risk, the fund's holdings have lower credit quality than most in the developed world, but still pretty strong quality. About half of its holdings are investment grade and the other half are split between non-rated and below investment grade.

While this adds risk, the fund is heavily diversified so if one country struggles I doubt the entire fund will (I see systemic "domino" risk as declining). Even more, considering the "high yield" funds (JNK) and (HYG) are 100% allocated to "below investment grade" and have a lower yield than EMLC by about 1-1.5%, it seems clear EMLC is undervalued. Even more, the fund's average maturity is 7.6 years which mitigates its long-term interest rate exposure.

Note, these are measured using multiple least squares on the daily returns of each asset. This lets us see what a 1% change in a given asset is expected to impact EMLC. The fund's highest exposure is the short-term treasury bonds (SHY) and, if they move 1%, EMLC is expected to move about 90bps. This makes sense because it implies U.S short-term yields are correlated to EMLC's yield. The fund also has heavy negative exposure to the U.S dollar simply because it holds local currency bonds. This makes it very valuable as a dollar hedge.

The Positive Catalyst

So, I think it is clear that EMLC offers a strong risk-reward payoff. It has a high dividend yield, is not highly exposed to most other assets, and offers a hedge against U.S inflation and dollar risk.

That last point has been negative for the fund so far as the U.S dollar's strength has driven down E.M currencies. While I still think a "blow-off top" in the U.S dollar is possible, I think growing U.S QE possibility may cause a (nasty) reversal in the coming months. If the dollar falls, the primary benefactor will be E.M currencies and funds like EMLC.

In my opinion, one of the best ways to forecast currencies is by their difference in interest rates. If a currency with similar inflation rates has a higher rate than another, demand for the higher-yielding currency will rise.

The dollar tends to appreciate when these spreads are higher and it tends to after they have declined a bit. Today, the differential is still high so the demand for the dollar may still be higher than other currencies, but we can see that the differential is clearly falling. In general, there seems to be a one year delay between the initial descent and its impact on the currency. This would imply the dollar is likely to fall in the coming months.

When the dollar begins to fall, it will be the E.M currencies that rise the most since fiscal and monetary instability is falling in E.M's while rising in the developed world.

The Bottom Line

Overall, for a long-term investor, I believe that EMLC is a great buy. In the short-run, I am largely undecided because I expect the U.S dollar to appreciate against it's developed market peers, but also expect E.M currencies to appreciate against those ones.

When most investors think of dollar and inflation hedges, they consider gold and bitcoin as the best alternatives. While I hold small positions in both for that reason, I also like yield and those assets don't have any yield. EMLC has the same dollar hedging qualities but delivers a stellar 6.5% yield along the way.

Frankly, I expect E.M currencies as a whole to appreciate at least 100% on the U.S dollar over the next ten years if not more so. I also expect interest rate yields to fall on these bonds which would be very bullish for the fund. While I'll refrain from giving an outright projection, I think it is safe to say the fund is likely to deliver strong low-beta risk-adjusted returns compared to other yielding assets.

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