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By Bloomberg

The last time developing nations’ local bonds were this expensive relative to their dollar debt, the biggest losses on record ensued. Some of the world’s largest fund managers say another selloff may be in the offing now.

Domestic notes sold by emerging-market governments have returned 2.5 percent this year in local-currency terms, the best start to a year since 2012, as interest-rate reductions from Indonesia to Romania cut yields to within 0.48 percentage point of equivalent dollar-denominated bonds. That’s too small a spread to reward buyers for the exchange-rate risk, according to investors including Fidelity Worldwide Investment and Pictet Asset Management Ltd.

“We remain cautious on emerging currencies, which ultimately has an influence on the argument of local versus dollar bonds,” said Simon Lue-Fong, who manages two of the world’s five largest emerging-market debt funds, totaling $12 billion, for Pictet in London. “The narrowing spread has been a reasonable indicator that dollar-denominated bonds will outperform.”

While the central banks of India and Turkey are among those that have lowered borrowing costs, boosting bond returns, traders expect most are running out of room for further cuts as stabilizing oil prices ease deflationary pressures and the prospect of interest-rate increases in the U.S. threaten to curb investment flows. The last time the spread was so narrow was June 2013, before signals from the Federal Reserve that it was ready to pare back monetary stimulus sent JPMorgan Chase & Co.’s local-currency bond index down 3.9 percent in three months, the most since the data started in 2003.

Real, Rupiah

This year’s rally in local-currency terms extends the gain over the past 12 months to 10 percent, topping the 6.7 percent return for emerging-market dollar debt, according to JPMorgan indexes. The extra yield investors demand to hold the notes instead of dollar-denominated securities dropped to a three-year low of 30 basis points last month, from a record 152 at the end of May, data compiled by Bloomberg show.

While local bonds have been paying less, exchange-rate losses have been growing. Currencies from Brazil’s real to Indonesia’s rupiah have tumbled this year on concern higher U.S. borrowing costs will suck capital from developing nations. JPMorgan’s gauge for emerging-market exchange rates reached an all-time low on Feb. 11, sliding more than 30 percent from a peak in 2011. The Bloomberg Dollar Spot Index has climbed more than 3 percent this year.

Rates Outlook

The strength of the dollar will spur a “flight to quality as investors prefer emerging-market hard-currency assets over emerging-market local assets,” Steve Ellis, a London-based money manager at Fidelity, said in a Feb. 12 e-mail. Local bonds offer “very little” premium, said Ellis, whose $888 million Emerging Markets Debt Fund returned 7.9 percent in the past year, beating 99 percent of peers, according to dollar-adjusted data compiled by Bloomberg.

By contrast, emerging-market dollar bond yields were 54 basis points above their five-year average, 367 basis points more than U.S. Treasuries, as of Feb. 23, data compiled by Bloomberg show.

Developing economies will grow 4.3 percent this year, the slowest pace since 2009, according to the International Monetary Fund. Even so, only Hungary, Poland, Turkey and India will lower borrowing costs further by year-end, based on interest-rate swap data from 14 major emerging markets compiled by HSBC Holdings Plc. Mexico and South Africa will join Brazil in raising rates, while Chile, South Korea and Malaysia will keep theirs on hold, the data show.

Fund Outflows

Lue-Fong, whose $5.7 billion Pictet Global Emerging Debt fund handed investors a 6.6 percent return in the past year, beating 74 percent of its peers, favors dollar debt from Indonesia, Brazil and South Africa, he said by e-mail Feb. 12.

There’s still money to be made in the local debt markets, according to Sergei Strigo, the London-based head of emerging- market debt and currencies at Amundi Asset Management, which oversees $980 billion.

“Active currency management is essential when investing in local-currency bonds,” Strigo, who recommends the domestic bonds of commodity-importing nations, such as Hungary, Turkey and Romania, while hedging the exchange-rate risk, said by e- mail on Feb. 13.

Foreign investors are mostly exiting domestic debt. Fund managers pulled about $800 million from the bonds this year through Feb. 18, according to data compiled by EPFR Global cited by Barclays Plc.

“What we’re concerned about are the currency valuations and the dollar story,” Mark Capstick, a London-based asset manager at BNP Paribas Investment Partners, which oversees the equivalent of $574 billion, said by phone on Feb. 18. Capstick has cut holdings of Indonesian and Thai local debt and is considering buying the international bonds of energy producers that carry higher yields.

“It’s getting more clearly evident that central banks are becoming increasingly comfortable with currency weakness as a way out of economic troubles,” he said.