Consider EM Local Currency Bonds as Rates Rise | ETF Trends

By Fran Rodilosso
Head of Fixed Income ETF Portfolio Management

Emerging markets central banks were ahead of developed markets in hiking rates, and we believe EM local currency bonds may offer yield and diversification potential as U.S. rates rise.

With yields over 7.6% (as of 4/30/2022), an allocation to emerging markets local currency sovereign bonds1 may be attractive as a way to diversify an income-oriented portfolio away from rising U.S. rates. Year-to-date, investors have not benefitted from the low correlation to U.S. bonds that has been observed historically. The asset class has returned -10.3%, which is only somewhat better than U.S. corporates and somewhat worse than the broad U.S. aggregate market.2 However, more than half of the negative return this year is attributable to the near complete loss of value of Russian bonds following the invasion of Ukraine, and an additional -2% of the year’s negative return has been driven by Eastern European countries most impacted by the conflict.3 Looking forward, we believe investors should consider the current makeup of the index, which has been relatively resilient and may benefit from several tailwinds.

Higher energy prices and commodity-led inflationary pressures have benefitted the currencies of several commodity exporting countries. In particular, the Brazilian real is up approximately 12.5% this year, contributing to most of the 13% gain in Brazilian sovereign bonds4 in U.S. dollar terms. The real’s gain is due in large part to the significant increases in the Brazilian central bank’s target rate over the past year to combat inflation (from 2% to 12.75%), as well as the positive impact of higher commodity prices on the country’s economy. Other Latin American currencies have also held their value (Mexican peso, Colombian peso) or appreciated (Uruguayan peso, Dominican Republic peso) versus the dollar this year, even as the dollar recently hit its highest level in nearly 20 years against developed markets currencies.5 In general, emerging markets central banks were far ahead of the Federal Reserve (Fed) and other developed markets central banks in hiking rates aggressively over the past two years. The result has been positive real rates of interest that have provided some support to currencies.

The yield advantage, in both real and nominal terms, helps to explain the relative resilience of the asset class in rising rate periods both currently (if one can adjust for the impact of geopolitical events) and historically. Further, although the Fed is at the beginning of what is expected to be a prolonged hiking cycle, historically higher U.S. rates have not been a headwind for investors once the U.S. hiking cycle actually begins. As shown in the chart below, the U.S. dollar appreciated in the year prior to the date of the first rate increase in three of the last five hiking cycles (including the current one). However, the dollar actually tended to be flat or weaker in the months following the first hike. If the same pattern repeats, emerging markets local currency bond investors may benefit from currency appreciation (or at least a pause in U.S. dollar strength) while earning higher levels of carry.

Broad U.S. Dollar and Historical Fed Rate Hiking Cycles

Broad U.S. Dollar and Fed Rate Hikes

Source: VanEck Research, Bloomberg. Cycles refer to periods in which the Federal Reserve increased the Fed funds rate.

As witnessed earlier this year, the potential for unexpected geopolitical and macroeconomic shocks is always a risk. The growth slowdown in China and additional inflation surprises in emerging markets are two risks we are watching closely. But with emerging markets central banks having a head start on the Fed and consequentially having greater policy flexibility going forward, and with the yield advantage of emerging markets still at an attractive level (approximately 450 basis points) by historical standards, we believe there is adequate compensation for risk. As the Fed embarks on what is expected to be a sharp rate hiking cycle, the diversification potential of the asset class from a portfolio construction perspective should not be overlooked.

Originally published by VanEck on May 18, 2022.

For more news, information, and strategy, visit the Beyond Basic Beta Channel.

1 Emerging markets local currency bonds measured by the J.P. Morgan GBI-EM Global Core Index.

2 Source: Morningstar as of 4/30/2022. Emerging markets local currency bonds measured by the J.P. Morgan GBI-EM Global Core Index; U.S. corporate bonds measured by the ICE BofA US Corporate Index; U.S. aggregate bonds measured by the ICE BofA US Broad Market Index.

3 Source: J.P. Morgan as of 4/30/2022.

4 Source: J.P. Morgan as of 4/30/2022.

5 Source: Bloomberg, as of 4/30/2022. As measured by the U.S. Dollar Index.

J.P. Morgan GBI-EM Global Core Index tracks bonds issued by emerging markets governments and denominated in the local currency of the issuer.

J.P. Morgan does not warrant the completeness or accuracy of the J.P. Morgan GBI-EM Global Core Index. “J.P. Morgan” is a registered service mark of JPMorgan Chase & Co. © 2022. JPMorgan Chase & Co. All rights reserved.

ICE BofA US Broad Market Index tracks the performance of US dollar denominated investment grade debt publicly issued in the US domestic market, including US Treasury, quasi-government, corporate, securitized and collateralized securities.

ICE BofA US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.

Please note that VanEck may offer investments products that invest in the asset class(es) discussed herein.

This content is published in the United States for residents of specified countries. Investors are subject to securities and tax regulations within their applicable jurisdictions that are not addressed in this content. Nothing in this content should be considered a solicitation to buy or an offer to sell shares of any investment in any jurisdiction where the offer or solicitation would be unlawful under the securities laws of such jurisdiction, nor is it intended as investment, tax, financial, or legal advice. Investors should seek such professional advice for their particular situation and jurisdiction.

This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.

Any investment in Emerging Market Bonds should be part of an overall investment program and should not be considered a complete investment program. Emerging Market Bonds are subject to risks associated with investments in below investment grade securities, credit, currency management strategies, debt securities, emerging market securities, foreign currency transactions, foreign securities, Latin American issuers, market, and sovereign bond risks. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest. Bonds and bond funds will decrease in value as interest rates rise. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future results.