This Emerging Markets Fund Could Surprise as Fed Boosts Rates

With the Federal Reserve raising interest rates and the potential for the pace of that tightening to increase, it’s understandably difficult for investors to be enthusiastic about fixed income assets.

That’s certainly true of emerging markets bonds and the related exchange traded funds — assets with established track records of faltering as U.S. interest rates rise. To be sure, these ETFs are struggling this year. The Invesco Emerging Markets Sovereign Debt ETF (PCY) is off nearly 23% year-to-date, but that could be a case of the punishment not fitting the crime.

Sure, plenty of bond market participants remember the drubbing that emerging markets bonds endured during the taper tantrum of 2013. However, the 2022 tightening cycle may be a case of history not repeating itself when it comes to developing economies’ sovereign debt.

“Conditions today are very different, giving EMs much more resilience. One key component is currency reserves, which gives a country a buffer to absorb any damaging impact of rising U.S. rates and a strengthening greenback,” according to Morningstar research. “A rule of thumb for adequate currency reserves, as popularized by Fed Chairman Alan Greenspan in 1999, is that a country should manage external assets and liabilities in a way to be able to live without new foreign borrowing for up to one year, which translates into 7% of GDP. In 2013, 8 of 13 developing countries were well below that threshold, but by the end of 2020, only 2 were.”

PCY, which tracks the DBIQ Emerging Market USD Liquid Balanced Index, sports a 30-day SEC yield of 8.61%, confirming that it compensates investors for the risks associated with emerging markets debt. Speaking of risks, emerging markets balance sheets are in much better shape today than they were in 2013.

“In 2013, among the most fragile countries, current-account deficits averaged about 4.4% of GDP, compared to just 0.4% by mid-2021, external resource flows had reduced significantly and real exchange rates were not as overvalued,” adds Morningstar.

Roughly a third of PCY holdings are rated investment-grade, while 56% carry junk ratings. The $1.93 billion ETF has a modified duration of 10.15 years. None of its country exposures exceed 3.16%, indicating that issuer risk is relatively subdued in the fund. Bottom line: PCY could ultimately prove to be less vulnerable to this round of tightening than investors are currently pricing in.

“When the world is experiencing tightening financial conditions, EMs tend to suffer more. But that suffering will be nowhere near what EMs experienced in past decades,” notes Morningstar’s Lorriane Tan. “This will not be 1997 all over again, with currency and debt crises.”

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.