Abating Risks in Emerging Markets Adds Intrigue to Bonds

Lauded for their yield, emerging markets (EM) bonds could be a compelling option even when taking credit risks into account. The macroeconomic environment in particular adds intrigue to funds like the Invesco Emerging Markets Sovereign Debt ETF (PCY).

The expectation of interest rate cuts certainly sets the stage for strength in EM bonds. In turn, a weakening dollar should also increase their attractiveness. But those factors aside, improving credit quality is also a reason to invest, especially for the risk averse considering EM bonds for their yield. Just a few years ago, that wasn’t the case, as rate hikes and a strengthening dollar soured investor tastes for EM bonds.

“The risk of government defaults in emerging markets this year is subsiding, stoking a rally in bonds that were just recently teetering on collapse and propelling junk-rated sovereign debt to its best start to a year since 2019,” Bloomberg reported.

However, the expectation of rate cuts in 2024 is reviving the interest in EM assets again, with bonds posting a banner year in 2023. Of course, EM bonds won’t have the allure of safer debt, as market experts still foresee headwinds for that particular corner of the bond market, but they’re in a much better place than before.

“Despite high interest rates, geopolitical instability and sluggish economic growth in China, emerging-market bonds posted strong returns in 2023,” an Alliance Bernstein report added. “While some headwinds may continue in 2024, we expect accommodative monetary policy, declining inflation and a weaker US dollar to provide support for the sector.”

Deep Diversification and Yield in One ETF

With a 30-day SEC yield of 6.89% as of March 28, PCY also adds deep diversification, with 95 holdings in its portfolio. Additionally, concentration risk is avoided, by keeping its allocation relegated to nothing above 3.5% of the fund’s assets.

PCY tracks the DBIQ Emerging Market USD Liquid Balanced Index (Index). The Index tracks the potential returns of a theoretical portfolio of liquid emerging markets U.S.-dollar-denominated government bonds issued by more than 20 emerging market countries.

To maintain its high yield, the average maturity date of a majority of its debt holdings fall within 20 years and beyond. While investors will have to be comfortable accepting the rate risk, improving macroeconomic conditions, as mentioned, could help abate those concerns. Furthermore, as the Federal Reserve finally institutes rate cuts, getting that yield now in tandem with price appreciation could also ease risk concerns.

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