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We expect a continuation of the local bond rally into 2009

While in recent years investor preferences have been clearly in favour of local currency debt, recent widening of spreads in dollar debt have made some investors wonder if an allocation to dollar debt would not make more sense.

However, we still see much better long-term (and in fact short-term) prospects for local emerging market debt for the following reasons:

1. Strong returns from two different sources

The key rationale for investing in emerging markets is their long-term transition to developed markets.

The transition to developed markets translates into returns via two important sources: firstly, capital appreciation through yield convergence to the much lower yield levels in developed markets; secondly, real effective currency appreciation as valuations move in line with developed market peers.

Local currency debt exploits both these sources of return, while dollar debt will only profit from long-term yield convergence.

2. Diversity of bond and currency returns

Not only do we expect currencies and bonds to contribute to returns, we would also note they perform differently at different points of the cycle. This characteristic can provide stability to overall returns.

3. Local debt has attractive risk return characteristics

Looking back through history, emerging market debt in general stands out as very attractive, offering double-digit returns (outperforming most equity categories) with bond-like volatility.

4. Liquidity is better in local debt

Local debt issuance has increased substantially in recent years, while growth in external debt has stalled. Local debt is now over 85% of all outstanding EM debt.

We believe this trend will continue as more and more governments see the benefit of developing deep and liquid local bond markets.

5. The US dollar is not without problems

Investing in dollar debt means 100% exposure to the US dollar. Particularly for non-US investors we would question the rationale for such an allocation, preferring to take on a diversified basket of emerging market currencies over 100% US dollar allocation.

The risks of currency weakness are not simply skewed against emerging market currencies in the current challenging global environment; the dollar, in our view, is also at risk of potential underperformance due to a series of factors.

6. Local debt offers better credit quality: A- vs BB+

Having a well developed local bond market is a sign of strength for a country.

It requires strong local financial institutions and acts as a catalyst for further economic development through, amongst other things, the development of a mortgage market and a local corporate bond market.

These positives are reflected in the average credit rating for the investable local government bond universe.

As measured by JP Morgan the overall credit quality of the main local bond index is A-. This contrasts with the overall credit quality of the main government dollar bond index of BB+ (below investment grade and four notches below local).

7. Huge dispersion of returns offers plenty of opportunity for alpha

Local debt offers a much wider opportunity set than dollar debt. For instance, we cover 59 countries and are able to access both bonds and currency, effectively doubling the opportunity set.

In addition, in most of these countries there will be additional opportunities through yield curve plays, credit and issue selection.