Here in the U.S., fixed income investors are dealing with a rough 2021 and are pondering the impact of a 2022 interest rate hike by the Federal Reserve.
Some global central banks are already hiking rates, but that’s not all bad news, as some exchange traded funds could benefit from that tightening. That group includes the VanEck J.P. Morgan EM Local Currency Bond ETF (NYSEArca: EMLC).
The $3.4 billion EMLC follows the J.P. Morgan GBI-EM Global Core Index, which is a basket of bonds denominated in local currencies from emerging markets sovereign issuers. On the basis of higher interest rates potentially lifting currencies, local currency bonds in developing economies could be propped up by the new rate-tightening regime.
“The market is currently anticipating further tightening across nearly all non-Asian economies as central banks react swiftly to inflation upside surprises, as well as higher than expected growth and improving labor markets,” says Fran Rodilosso, VanEck head of fixed income ETF portfolio management.
More than 20 emerging markets currencies are represented in EMLC — just five of which are Asian currencies. The fund’s third-largest country weight is Brazil at 8.67%. Latin America’s largest economy recently boosted borrowing costs, and market observers widely expect that trend to continue as the central bank there looks to ward off inflation.
One of the reasons the Fed is considering a 2022 rate hike is inflation, and that’s a primary reason that emerging markets central banks are already raising borrowing costs.
“EMs do not have the same ability to tolerate higher than normal inflation, and for the last two decades have kept a closer eye on financial stability concerns, given their dependence on external funding. Central bankers have remained vigilant amid high inflation readings, maintaining their credibility and reliance on conventional monetary policies to keep inflation expectations in check,” adds Rodilosso.
EMLC, which yields 5.20%, has an effective duration of 5.02 years, putting it in intermediate-term territory. The fund allocates about 26% of its weight to Latin American economies, which are often inflation-sensitive and home to central banks that have dealt with rising consumer prices in the past, meaning that they’re often swift to raise rates when inflation inches higher. Plus, there’s rate differential opportunity with EMLC.
“Further, the rate differential between EM local currency bonds and U.S. interest rates, which was nearly at the lowest level in a decade going into the pandemic, has increased significantly this year,” concludes Rodilosso. “In nominal terms, the yield differential has moved out to approximately 4.1 percentage points, from 3.6 at the beginning of the year, and 3.4 at the beginning of 2020. This increased buffer provided by market interest rates may also help provide support for currencies, in our opinion.”
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