Conventional fixed income wisdom holds that high interest rates in the U.S. are problematic for emerging market debt and related ETFs.
That scenario has played out this year, particularly for emerging market bonds denominated in local currencies. With the Federal Reserve disappointing when it comes to rate cuts and the dollar still sturdy, the VanEck J.P. Morgan EM Local Currency Bond ETF (EMLC) lost 3.8% in the first six months of 2024. Relative to the longer-ranging developing world debt, EMLC may have been punished too severely this year.
That thesis is bolstered by the fact that the ETF isn’t a long duration product. Its duration is just 4.86 years. And over 71% of its holdings carry investment-grade ratings. Regarding the latter point, there have been no sizable defaults of emerging markets sovereign issues this year. Plus, there are more positives supporting emerging market bonds, and perhaps EMLC as well.
Evaluating EMLC’s Compelling Attributes
On a stand-alone basis, EMLC’s 30-day SEC yield of 6.38% is attractive. That’s because it is well above what investors earn with developed market bonds. EMLC’s yield is even more enticing because, historically, the higher a bond’s yield is when investors initially get involved, the shorter the odds are of success.
Additionally, sovereign spreads — which measure the compensation investors gain for taking on added risk over Treasurys — aren’t yet tight. That confirms there might be value available with assets such as EMLC.
“While EM spreads may have tightened, overall yields remain high relative to history,” noted Allianz. “The yield on the overall index … is at a sound 8%, with the high yield index still above 10% despite the move lower in recent months. This high carry (gains made from bond income over time) boosts total return prospects and is an important driver of value in our view.”
It’s also possible that emerging market bonds — including issues held by EMLC — have been hindered by weakness in China’s property. That has experienced multiple defaults. However, contagions have not occurred. And historical data suggests that by avoiding developing world debt based on the events in a single country can be hazardous to long-term returns.
“Those shunning EM allocations would have missed out on potentially strong returns, which over time have outstripped more mainstream fixed income risk assets such as US high yield bonds,” concluded Allianz. “Over the years contagion around EM defaults and geopolitical crises has become more contained. Today the universe is much larger and more diverse. [That means] idiosyncratic issues in one or two countries don’t tend to lead to perceived higher default risk in others.”
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