If the Federal Reserve maintains a slow and gradual interest rate hike schedule, fixed-income investors may turn to emerging market bond exchange traded funds to capture higher yields.
“We believe emerging market (EM) assets, particularly currencies and select sovereign bonds, may provide the best investment opportunities in the current low-yield environment – a condition that should persist into 2016, irrespective of any rate normalization policies from the Federal Reserve (Fed) or Bank of England,” Brandywine Global said in a Legg Mason research note.
Brandywine Global argues that accommodative policies and central bank activism will continue to support emerging market debt. Moreover, as the European Central Bank engages in loose monetary policies, the increased liquidity out of the Eurozone could also find its way into higher-yielding emerging markets.
However, Brandywine Global warned that the strong U.S. dollar remains a major headwind for the developing economies.
“A major aspect of our outlook relies on weakening G3 currencies — namely the U.S. dollar. Therefore, continued dollar strength remains a key risk. A strong dollar would continue to distort crude oil prices — and commodity prices generally — and ultimately detract from EM growth. Furthermore, the dollar could potentially rally, drawing liquidity away from EM assets,” Brandywine Global added.
Consequently, if the U.S. dollar continues to strengthen against global currencies, investors may want to look to USD-denominated emerging market debt as opposed to local currency-denominated EM securities. For instance, the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEArca: EMB) tracks U.S. dollar-denominated emerging market government bonds across more than thirty countries, including 6.7% Mexico, 5.6% Russia, 5.4% Turkey, 5.3% Indonesia and 5.1% Philippines, among others. EMB has a 6.91 year duration and a 5.64% 30-day SEC yield.
The PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY) also includes a group of USD-denominated emerging market government bonds. Top country allocations include Ukraine 6.9%, Russia 4.0%, Latvia 3.8%, Pakistan 3.7% and Romania 3.7%. PCY has a 7.78 year duration and a 6.18% 30-day SEC yield.
The Vanguard Emerging Markets Government Bond ETF (NasdaqGM: VWOB) tracks USD-denominated emerging market debt, with top countries including China 13.0%, Mexico 8.4%, Brazil 7.7%, Russia 7.3% and Indonesia 5.8%. VWOB has a 6.3 year duration and a 5.39% 30-day SEC yield.
Max Chen contributed to this article.