Global bond risk linked to exchange rates - Another issue with the search for yield

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The search for yield knows no bounds and leads to cross-market linkages. Investors have become more international in their search for yield and returns. Certainly with negative rates, the yield opportunities within many countries are, to say the least, limited. Consequently, capital will flow elsewhere especially to emerging markets. This creates a new set of balance sheet problems for investors because they both face and create currency risk. Shocks to bilateral exchange rates will create a funding mismatch on the balance sheets of global investors. These currency-funding mismatches will spillover to the price of local EM bonds. Additionally, their flows associate with bond transactions in and out of a country may impact exchange rates. 

This link between capital flows, investor balance sheet risk and credit means there is a well-defined relationship between exchange rate changes and local currency emerging market bonds. The currency rate is a risk attribute for EM bond spreads. (See BIS Working paper 775 Bond risk premia and the exchange rate)

When local yields fall, currencies tend to appreciate which makes bond returns more sensitive to currency fluctuations. Put another way, dollar durations are higher than local currency durations. There is also a negative association between local bond spreads and currency appreciation. Interestingly, the link between currencies and credit spreads is not with the trade-weighted exchange rate but with the dollar exchange rate. The impact of an appreciation of the trade-weighted currency will have the opposite impact on spreads. A trade-weighted appreciation will have a negative impact on growth and thus increase credit spreads.  Hence, investors need to watch both bilateral and trade-weighted exchange rates when making local currency bond investments.

These conclusions suggest that the decision to invest and the impact on credit spreads are associated with the set of other opportunities around the globe. You cannot separate the credit decision from what is happening to the currency. This link will become more apparent if we see greater swings in the dollar from changes in monetary policy. If the Fed makes a move, which impacts the dollar, local bond markets around the world will feel it.