EM Bonds Could Be Way to Deal With Fed Tightening | ETF Trends

As the Federal Reserve closes in on the start of a new interest rate tightening regime — one that could bring as many as four hikes, perhaps more — fixed income investors are understandably pensive.

An avenue for contending with higher interest rates in the U.S. is emerging markets bonds, which are accessible via a variety of exchange traded funds, like the VanEck J.P. Morgan EM Local Currency Bond ETF (NYSEArca: EMLC).

With the Fed about to boost rates, many advisors are considering the duration vs. yield tradeoff. However, many of the favored domestic fixed income assets that investors flock to when rates rise present market participants with credit risk, liquidity issues, or both. Those factors could be indicators that EMLC is a credible bond ETF idea for 2022.

“We believe emerging market bonds remain part of the solution set, with attractive yield versus duration tradeoffs in some EM asset classes, and without as significant a quality or liquidity tradeoff as other high yielding options represent,” says Fran Rodilosso, VanEck head of ETF fixed income portfolio management. “EM debt may provide a relatively insulated pocket of opportunity to help build more resilient bond income portfolios in this environment.”

The $3.5 billion EMLC holds 358 bonds and sports a 30-day SEC yield of 5.8%. Not only is that well above what investors find on most domestic fixed income funds, but that yield is relevant because higher yields can offset set bond price declines as rates rise.

However, EMLC could be insulated from big declines as 2022 moves along because many emerging markets already raised interest rates to damp inflation. The average benchmark lending rate for emerging markets central banks is trending higher, and over the past 90 days, 45% of those central banks boosted borrowing costs. Plus, there’s a case for emerging markets currencies, which are what EMLC holdings are denominated in.

“The benefits to EM local currency investors are a more substantial level of income that is not eroded by loss of purchasing power (through a potentially weaker currency) and the potential for rate cuts to stimulate growth, if needed. The supportive case for emerging market currencies begins with valuations, which have been deeply discounted relative to their history for several years,” adds Rodilosso.

As the VanEck strategist notes, in the two inflationary/rising rates periods since 2000, emerging markets sovereign debt topped domestic aggregate bond and junk bond strategies.

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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.