• Emerging Markets Bonds

    EM Local Currency Bonds as a Portfolio Stabilizer

    Fran Rodilosso ,CFA, Head of Fixed Income ETF Portfolio Management
    02 September 2019

    The reversal in developed markets interest rates over the past year provides a useful case study of how changing market expectations around developed markets rates impacts emerging markets bonds. As shown in the chart below, expectations for a rate hike at the recent 31 July 2019 U.S. Federal Reserve (Fed) meeting began to collapse in November 2018 amid concerns of a growth slowdown. Equities and high yield bonds suffered as a result, but emerging markets local currency bonds were surprisingly resilient during this market volatility.

    Emerging Markets Local Currency Bonds Outperformed Amid Changing Rate Expectations

    Emerging Markets Local Currency Bonds Outperformed Amid Changing Rate Expectations

    Source: Morningstar and Bloomberg as of 31/7/2019. Emerging Markets Local Currency Bonds is represented by the J.P. Morgan GBI-EM Global Core Index. U.S. Equities is represented by the S&P 500. U.S. High Yield Bonds is represented by the ICE BofAML U.S. High Yield Bond Index. Emerging Markets Equities is represented by the MSCI Emerging Markets Index. Past performance is no guarantee of future results. For illustrative purposes only.

    Although emerging markets local currency valuations remain far below the levels of early 2018 and are very beaten down relative to historical levels, the change in rate expectations has provided support to local currencies, while the attractive yields earned on the asset class have provided investors with a fairly steady source of return. On the other hand, U.S. equities, high yield bonds and emerging markets equities experienced larger drawdowns and elevated volatility over the period, resulting in both lower risk-adjusted and absolute returns.

    The primary risk to emerging markets local currency bonds is a slowdown in global growth, and the unexpected increase in trade tensions between the U.S. and China should be closely monitored. Growth concerns have in fact been one factor in negative returns for emerging markets local debt in August.  But a larger factor has been a rapid decline in the Argentine peso in reaction to primary election results. One reason an index approach to emerging markets local bonds has worked well is that idiosyncratic risk can lead to high volatility in various emerging markets local markets, particularly the highest yielding ones. A well-diversified portfolio can take advantage of the overall high yields in the asset class while avoiding highly concentrated exposures to a single currency.

    However, we believe several tailwinds will provide support to the asset class: prolonged low rates across developed markets, emerging markets monetary policy that has turned dovish and historically low valuations of emerging market currencies. With their attractive yield potential, diversification benefits and recent resiliency amid these changing market conditions, we believe emerging markets local currency bonds may be an attractive addition to fixed income portfolios.