Bonds Could Be Strong Emerging Markets Bets in 2023 | ETF Trends

Fixed income investors know that 2022 was rough for domestic bonds. Seven interest rate hikes by the Federal Reserve will do that, but the turbulence wasn’t confined to U.S. fixed income assets.

Due in large part to the dollar soaring on the back of those rate hikes, dollar-denominated emerging markets bonds tumbled. Down 20.16% year-to-date, the Vanguard Emerging Markets Government Bond Index Fund ETF Shares (VWOB) paints the picture of emerging markets debt weakness.

However, some market observers believe the new year could bring better things for emerging markets debt, indicating VWOB could be a high-yield rebound idea worthy of consideration by income investors.

“We stick with credit over equities in emerging markets (EM), too. EM debt has outperformed EM equities by 395% since 1991,” notes Bank of America. “EM equity risk remains high. EM debt has only been in a bear market 4.5% of the time in the past 30 years compared to 33% of the time for EM equities. EM debt funds also have just 2-4% direct exposure to China.”

VWOB, which follows the Bloomberg USD Emerging Markets Government RIC Capped Index, holds 754 bonds, none of which account for more than 0.64% of the ETF’s portfolio. The $3 billion ETF stands to benefit if the dollar depreciates next year — a relevant point because the bonds held by VWOB are priced in the U.S. currency.

“Our currency strategists also expect the US dollar to peak in 1Q23, which should help assuage default concerns. Jane Brauer expects 11% returns for EM debt next year. We prefer EM external debt, which has outperformed local-currency bonds by 4.25% per year since 2013,” adds Bank of America.

VWOB has an average duration of 7.4 years, putting it firmly in intermediate-term territory. There are some benefits to that classification, including the potential for reduced correlations to equities and longer-dated bonds.

Another possible perk that could accrue to VWOB next is that some emerging markets central banks could hold back on rate hikes because they started their rate-tightening regimes prior to the Federal Reserve. Additionally, VWBO yields an attractive 4.76%. That’s compelling not only from an income perspective, but also due to historical precedent.

“EM debt yields (7%) also look relatively attractive relative to volatility. Buying yield/vol peaks has historically resulted in double digit returns over the subsequent 12 and 24 months,” concludes Bank of America.

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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.