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  • Emerging Markets Bonds

    EM Bonds: A Winner in the Race to Cut Rates?

    Fran Rodilosso, CFA, Head of Fixed Income ETF Portfolio Management
    July 24, 2019
     

    Lower interest rates in developed markets have been the key driver of emerging markets debt returns so far this year, despite several idiosyncratic stories and emerging markets central banks that have until recently exhibited an overall tightening bias. In our view, the shift in policy globally is creating a potential runway for emerging markets currencies (EMFX) to possibly fare better versus the U.S. dollar, and for emerging markets central banks to, partly as a consequence, take a more dovish stance with regard to their own interest rate policies.

    The key question is whether current interest rate levels reflect fundamentals such as expected growth and inflation, or if they are being priced to expected central bank policy in the U.S. and Europe (which may or may not reflect economic fundamentals). We believe, if current rate levels are reflective of expected fundamentals, caution may be warranted. The negative impact to EMFX of slowing growth or an impending recession would likely outweigh the incremental benefit of lower rates to emerging markets local currency bonds. Spread sectors such as corporate bonds may also underperform as the credit cycle turns and spreads and defaults increase. In our view, a more benign “goldilocks”1scenario of continued slow growth supported by low interest rates, on the other hand, would be a more favorable environment in which we think investors may benefit from being tactical within these asset classes.

    We believe that market expectations for lower rates are based on a view of central banks’ willingness to be extremely cautious about protecting growth and asset prices, and are not reflective of an impending end to the economic or credit cycle. If correct, this would be bullish for most asset classes and favor taking on more risk within fixed income portfolios. In this scenario, we believe emerging markets local currency bonds would fare particularly well. Many emerging markets central banks would have room to cut rates, potentially boosting local interest rate driven returns which have already provided the bulk of total return this year, while a weaker U.S. dollar could provide some lift to relatively stagnant EMFX returns. Even an environment of flat currency returns may be favorable for emerging market local currency bond investors, given the attractive carry the asset class currently provides with a yield of 6.7% as of June 30, 2019.

    YTD EM Local Bond Returns Driven by Local Rates, While EMFX Has Lagged

    YTD EM Local Bond Returns Driven by Local Rates, While EMFX Has Lagged

    Source: JP Morgan. Data as of 7/12/2019.

    Emerging markets corporate bonds may also be attractive for investors not willing to assume currency risk, as returns will be anchored by U.S. rates while spreads may find support from central bank stimulus. We continue to favor the high yield segment of this market due to its attractive risk/reward in light of healthy and improving credit fundamentals.

    For more on how to position a fixed income portfolio in the current environment, see CEO Jan van Eck’s latest investment outlook: Is There Enough Risk in Your Fixed Income Portfolio?

     

    1A goldilocks economy is an economy that is not so hot that it causes inflation and not so cold that it causes a recession.

    DISCLOSURE

    Please note that Van Eck Associates Corporation serves as investment advisor to investment products that invest in the asset class(es) included herein.

    This content is published in the United States for residents of specified countries. Investors are subject to securities and tax regulations within their applicable jurisdictions that are not addressed in this content. Nothing in this content should be considered a solicitation to buy or an offer to sell shares of any investment in any jurisdiction where the offer or solicitation would be unlawful under the securities laws of such jurisdiction, nor is it intended as investment, tax, financial, or legal advice. Investors should seek such professional advice for their particular situation and jurisdiction.

    The information herein represents the opinion of the author(s), but not necessarily those of VanEck, and these opinions may change at any time and from time to time. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. Historical performance is not indicative of future results. Current data may differ from data quoted. Any graphs shown herein are for illustrative purposes only.

    All investing is subject to risk, including the possible loss of the money you invest. Bonds and bond funds will decrease in value as interest rates rise. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future results.