Winter Is Coming, but Wall Street Is Warming Up to EM Bonds Again

Investors have turned cold to emerging markets (EM) bonds for most of 2022, but they could be warming up to riskier debt again as winter draws closer.

EM assets in general have faced a full-blown gust of headwinds with a stronger dollar amid rising interest rates. Because EM assets are often tied to the performance of the local currency, a stronger dollar has been weakening EM buying power in an economic environment where inflation is high.

The MSCI Emerging Markets index paints a picture of EM weakness with the index down over 20% for the year. However, the bottom has to hit at some point, and Wall Street may be wondering whether it’s time to re-think EM assets again, particularly bonds.

“Wall Street banks are raising their outlook for emerging markets’ hard-currency bonds as a slowdown in U.S. rate hikes could provide some breathing space for the embattled asset class,” a Reuters article said.^MSEM Chart

Global investment firms like Morgan Stanley anticipate a brighter outlook moving forward for EM bonds. At some point, central banks will have to stop raising rates to the detriment of economic growth, and that scenario could be just around the corner.

“We move into the final weeks of 2022 with an anticipation of better months ahead for EM fixed income investors,” Morgan Stanley’s James Lord wrote in a note to clients, according to the Reuters article.

“The key call behind the positive total returns is the expectation that inflation globally falls in 2023,” Lord added.

Consider VWOB for EM Exposure

One convenient way to get EM bond exposure with a focus on safer government bonds is via exchange traded funds (ETFs) that can offer an all-inclusive approach as opposed to holding various debt issues. One fund to consider is the Vanguard Emerging Markets Government Bond Index Fund ETF Shares (VWOB).

VWOB seeks to track the performance of a benchmark index that measures the investment return of U.S. dollar-denominated bonds issued by governments and government-related issuers in emerging market countries. The fund employs an indexing investment approach designed to track the performance of the Bloomberg USD Emerging Markets Government RIC Capped Index.

Getting exposure to EM debt doesn’t have to come at a great expense, especially given the 0.20% expense ratio for VWOB. For that low cost of entry, the fund also comes with a 30-day SEC yield of 7.17%, as of November 22.

The average duration for the fund’s holdings is around seven years, giving the fund intermediate-level exposure to help capture yield while also limiting duration risk — essentially the best of both worlds in a continuously challenging bond environment where central banks are tightening monetary policy. In terms of country allocations, the top country exposure includes Mexico, Saudi Arabia, and Indonesia.

As mentioned, to mitigate rate risk, the fund focuses mainly on short- and intermediate-term debt, especially in the current market. 30% is allocated to debt maturing in one to five years, while another 30% is allocated to debt maturing in five to 10 years.

For more news, information, and strategy, visit the Fixed Income Channel.