EM Local Currency Bonds Shine as U.S. Dollar and Rates Wobble

Emerging markets (EM) local currency sovereign bonds have strongly outperformed other major global fixed income asset classes this year. The U.S. dollar has been notably weak year to date through May 13, 2025, declining approximately 7% versus a basket of developed markets trading partners. However, the strength of emerging markets currencies, which have gained approximately 4% year to date, only explains about half of the return this year of the JP Morgan GBE EM Core Index. The remainder of the return this year is explained by local interest rates and bond price movements, with a yield of over 7% generating significant income return.

EM Local Currency Bonds Have Strongly Outpaced Most Of Their Peers

Source: J.P. Morgan and ICE Data Indices as of 5/13/2025. EM Local Sov represented by J.P. Morgan GBI-EM Global Core Index; Global Broad Market represented by ICE BofA Global Broad Market Index; EM USD Sov represented by J.P. Morgan EMBI Global Diversified Index; Global DM Sov represented by ICE BofA Developed Markets Sovereign Bond Index; US HY Corp represented by ICE BofA US High Yield Index; US Broad Market represented by ICE BofA US Broad Market Index; US IG Corp represented by ICE BofA US Corporate Index.

EM local bonds lagged most other fixed income in the first five years of the past decade. However since then, they have outperformed all of the segments shown above, other than U.S. high yield corporates and U.S. dollar-denominated EM sovereign bonds. However recent performance of EM local bonds stands out, particularly following the U.S. tariff announcement on April 2, 2025, or “Liberation Day,” when U.S. rates increased sharply while the U.S. dollar also depreciated. Several possible explanations for the weakness in U.S. fixed income (and U.S dollar assets generally) have been put forth including a decline of confidence in U.S. institutions and doubts around the U.S. dollar’s role as a reserve currency, unwinds of leveraged basis trades and selling of U.S. Treasuries by foreign central banks. It is possible that a combination of these or other factors explain what has been observed. In any case, we believe the case for diversification outside of U.S. rates and the U.S. dollar has become stronger, and EM local currency bonds are an attractive way to achieve this within a fixed income portfolio.

In addition to diversification benefits, we believe EM fundamentals also justify an allocation to EM local bonds. Developed markets economies are characterized by very high debt-to-GDP ratios, fiscal deficits, and increasing political dysfunction. In addition to lower debt levels and more disciplined fiscal policy, emerging markets have benefited from independent central banks that have prioritized keeping inflation under control. For example, most EM central banks hiked policy rates swiftly and decisively soon after the COVID pandemic started, getting ahead of inflation. The results have been both high real and nominal interest rates. Sticky inflation and geopolitical conflict may also keep commodity prices elevated, benefiting the currencies of commodity exporting countries such as Brazil, Indonesia, and South Africa.

EM bond mutual fund and ETF flows have been significantly negative over the past several years¹, indicating that many investors remain underallocated to the asset class. As a result, renewed interest may set up a favorable technical backdrop. Along with favorable fundamentals, the ability to diversify away from U.S. rate and dollar risk, and achieve a yield of over 7%, we believe it’s time to take another look at EM local currency bonds.

¹ Source: Morningstar Direct, as of 4/30/2025.