Investors were well compensated for investing in riskier fixed income sectors in 2012. With U.S. Treasuries and investment-grade securities offering reduced income potential, many investors rushed to higher-yielding sectors in what could be characterized as a relentless pursuit of income.
Total returns for sectors such as U.S. High Yield and Emerging Market (EM) USD Sovereigns were bolstered by significant compression in the additional amount of yield that investors demand for assuming credit risk. EM local currency debt also enjoyed significant principal returns as local rates declined in step with aggressive central bank rate cuts.
We believe 2013 will be a different story. Selectivity and fundamentals are poised to play a more critical role in generating returns this year. In other words, the relentless pursuit of income may evolve into a more prudent pursuit of income. Investors and managers may more selectively target opportunities and anticipate lower absolute returns but continue to search for additional ways to generate income in their portfolios.
Looking ahead, investors should be asking what the primary driver of returns in fixed income will be in 2013. In emerging markets, we believe a majority of central banks have completed their cycle of interest rate cuts. This year, we believe that returns from EM local debt will largely be comprised of interest income and returns from currency appreciation against the U.S. dollar.
While we believe there will be a more balanced return (between income and currency appreciation) from EM local debt in 2013, we think a bias toward quality will offer differentiated performance to investors this year. Similar to our note about EM currency performance in 2012, EM Europe performed well after unnerved markets were calmed by the European Central Bank’s (ECB) debt purchasing scheme. Going forward, we believe EM Asia and EM Latin America should perform well when a focus on economic fundamentals returns to the market.
That said, last year the WisdomTree Emerging Markets Local Debt (NYSEArca: ELD) had its best calendar year performance since its inception in 2010. In fact, emerging market local debt as an asset class had better returns than even high-yield debt in 2012 thanks to aggressive interest rate cuts by many EM central banks.1 While the future path of U.S. fixed income may be subject to debate, we believe investors should also be focusing on the potential drivers of return in international fixed income and emerging markets when making portfolio allocation decisions.