For a significant portion of last year, the dollar was sluggish and the outlook for U.S. interest rates sanguine, catalysts that bolstered the case for emerging markets debt and exchange traded funds, such as the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEArca: EMB).
If the Federal Reserve hikes rates, emerging market companies that borrowed overseas are more susceptible to foreign capital swings and could find it more difficult to refinance debt. Moreover, a strengthening dollar makes it costlier to pay off dollar-denominated bonds.
With the specter of rising rates increasing, proper evaluation of emerging markets bond funds takes on heightened importance. That means avoiding the ETFs with heavy exposure to the largest countries with the biggest debt loads.
Fundamentals in the emerging economies continue to strengthen with increased expected growth, stabilizing commodities market and narrowing deficits.
Consequently, investors may still find value and generate attractive yields through emerging market debt, even with the increased likelihood of a rate hike or multiple hikes sometime this year.
“Meanwhile, we have cut our views of EM debt and Asian fixed income to neutral from overweight. We see long-term opportunities in EM bonds, but higher valuations make us more balanced in the shorter term. We remain positive on EM equities, where valuations are not a constraint,” said BlackRock in a note out Tuesday.
Last year’s enthusiasm for emerging markets bonds stoked sizable inflows to EMB, making it the world’s largest bond fund of any variety. EMB’s Europe-listed counterpart became the fifth-largest emerging markets bond fund.
However, some market observers are concerned the emerging markets bond trade is becoming a crowded trade. While yields in developed economies remain depressed, with some even trading with negative yields, emerging market bonds have quickly gained traction as one of the few areas left with attractive yields.
Emerging currencies have strengthened on improving commodity prices, notably the rebound in crude oil prices, as many developing economies are major exporters of raw materials.
Consequently, more investors are looking to emerging market yields, despite the risks associated with the developing economies.
Debt-to-GDP ratios in developing economies are far below those seen in the U.S. and the Eurozone.
For more information on the fixed-income market, visit our bond ETFs category.