By William Sokol
Director of Product Management
Emerging markets in general moved much quicker than the U.S. and other developed markets to increase rates to stay ahead of inflation, which has resulted in higher nominal and real yields. In addition, emerging markets local currency investors benefit from a more substantial level of income that is not eroded by loss of purchasing power (through a potentially weaker currency) as well as the potential for rate cuts to stimulate growth if needed. In this Q&A, we answer frequently asked questions about investing in emerging markets local currency bonds and specifically about the VanEck J.P. Morgan EM Local Currency Bond ETF (EMLC).
- How big is the market for emerging markets local currency bonds?
- Why do countries issue bonds in local currency?
- What are the benefits of investing in EM local currency bonds?
- What drives the risk and return of EM local currency bonds?
- Are EM local currency bonds a replacement for hard currency EM bonds?
- Why might now be a good time to consider adding exposure to EM local currency bonds?
- How can investors access EM local currency bonds?
- How can investors buy VanEck ETFs?
How big is the market for emerging markets local currency bonds?
The emerging markets local currency bond market is substantial in size, and larger than many investors who are new to the asset class may realize. EM local currency bonds comprise nearly 60% of the investable emerging markets debt universe and is over 2.5x the size of the U.S. dollar denominated, or “hard currency,” EM sovereign market. However, nearly 90% of U.S. mutual fund and ETF assets are in hard currency EM bonds, suggesting that investors may be under-allocated to this asset class based on its size. Exposure in global bond benchmarks is also generally low or non-existent, so many investors are not getting exposure to this asset class through global bond funds.
EM Local Currency Represent Nearly 60% of the EM Debt Universe
The size of the market overall, and the development of individual local markets over the past several decades, has resulted in deep and liquid markets for many countries’ local currency bonds. Local investors such as banks, pension funds and insurance companies have helped drive active secondary market trading, along with increased offshore investor interest and more recently, an increase in trading activity through electronic trading platforms.
Why do countries issue bonds in local currency?
Issuing local currency denominated bonds is an option that many emerging markets have increasingly chosen over the past few decades. There are several reasons for this. First, demand has been increasing from both international investors as well as a growing local investor base in many countries, which has helped boost liquidity.
Second, local currency debt can help make a country more resilient against external shocks in terms of its ability to service its debt. Although hard currency debt may appeal to offshore investors due to the lack of direct currency risk, it can be more costly for the sovereign issuer, if the value of the dollar appreciates relative to their currency. Accordingly, investors in hard currency debt may be taking on higher credit risk in exchange for lower direct EMFX risk. This can be a particular concern in risk-off periods or if an individual country begins to encounter stress. In such a situation, international investors may reduce their exposure to the country, which will generally reduce the value of the local currency (as investors sell local assets) and increase the cost of funding. As a result it becomes more expensive to service hard currency debt. In the worst case, the sovereign may need to seek emergency funding or may even default.
Local currency debt, on the other hand, is much more insulated from these dynamics. Although existing investors may see the value of their holding decline as yields increase and the local currency depreciates, the issuer’s ability to service the existing debt is not as impacted by the value of the currency relative to the U.S. dollar. That is not to say that default cannot occur in local currency debt, particularly in unique circumstances such as what happened with Russian debt in 2022 following the invasion of Ukraine. However, generally speaking, the issuer bears less currency risk and as a result is better insulated from external shocks.
What are the benefits of investing in EM local currency bonds?
We believe the investment case for emerging markets local currency bonds generally comes down to yield and diversification benefits within a broader portfolio. The asset class provides a significant yield pickup over both U.S. investment grade corporates and global bonds. Although the yield is somewhat lower than U.S. high yield bonds and hard currency sovereign bonds, the local currency universe is primarily investment grade, so should be compared to other asset classes through that lens. Versus other high quality fixed income asset classes, local currency bonds are attractive in terms of yield.
EM Local Currency Bonds Offer Yield Pickup vs. U.S. IG and Global Bonds
Largely due to the EMFX exposure, local currency sovereign bonds exhibit low correlation to U.S. dollar denominated asset classes. EM local currency bonds are less directly impacted by U.S. monetary policy and the movement of U.S. Treasury yields. Accordingly, the correlation between EM local currency bonds and U.S. Treasury bonds over the past decade is 0.10, compared to a 0.90 correlation between U.S. Treasuries and U.S. aggregate bonds1. This means that the returns of the asset class may offset poor returns in other asset classes in a given year. For example, 2022 was a very difficult year for most U.S. fixed income asset classes, but EM local currency bonds outperformed U.S. aggregate bonds by approximately 3% during the calendar year. EM local currency bonds also exhibit a lower correlation to “risky” asset classes such as high yield bonds and U.S. equities versus hard currency emerging markets bonds.2
Emerging markets local currency bonds can also provide issuer and regional diversification within a portfolio. Compared to the hard currency emerging markets bond universe, the universe of local currency bond issuers is distinct. Generally, to be able to issue in the global market in a local currency, an issuer will have more established legal and regulatory systems, larger economies, higher credit ratings and more developed local capital markets. In addition, compared to emerging markets equities, the regional exposure of local currency bonds is significantly different, with exposure to Asia, Latin America and emerging Europe ranging from 23-36%, versus nearly 80% Asia exposure in the broad emerging markets equity benchmark3.
What drives the risk and return of EM local currency bonds?
The risk and return of EM local currency bonds is driven by two distinct factors: local interest rates and changes in the value of the currency. The local rates component includes both carry, or the amount earned from holding the bond (i.e. the yield), as well as price appreciation or depreciation as local interest rates change. As mentioned above, yields on emerging markets local currency bonds have historically been significantly higher than other investment grade fixed income asset classes. And for U.S. investors, although the value of local currency bonds will be impacted by changes in local rates, changes in U.S. bond yields will not have a direct effect.
The second component of return, local currencies, is unique to local currency denominated bonds compared to hard currency bonds or other U.S. dollar denominated fixed income asset classes, thus providing diversification benefits within a portfolio. Historically, this component of return has tended to be a bigger driver of volatility, including to the downside. For example, EMFX returns have been negative in 2020, 2021 and 2022 amid relentless U.S. dollar strength, and significantly and negatively impacted total returns in those years. Generally speaking, the most painful years of the past decade for the asset class were a result of EMFX depreciation, not duration, and local rates generally contributed positively to returns in most years. Interestingly, however, in years such as 2016, 2017 and 2019, in which the asset class experienced strong returns, EMFX was not the primary driver and in two of those years contributed only a negligible amount to total return.
Although some investors view emerging markets local currency bonds as primarily a play on the strength of the U.S. dollar, we believe the appeal of the asset class lies largely in the less volatile returns from the relatively high level of carry. Further, strengthening local currencies (or a weakening dollar) are not a condition for attractive returns, which can be achieved in periods with U.S. dollar stability.
Currencies and Local Rates Drive EM Local Currency Returns
Are EM local currency bonds a replacement for hard currency EM bonds?
We believe EM local currency bonds have a role in a diversified global bond portfolio as either a complement or replacement to hard currency EM bonds, depending on an investor’s objective. There are reasons to consider an allocation to both asset classes, given the different risk and return profiles. As shown below, hard currency bonds have a much higher tilt towards high yield issuers, resulting in a higher overall yield. Issuing in dollars gives countries the ability to issue longer duration bonds, so a mix of the two asset classes provides exposure to both U.S. rates duration as well as local interest rates. And because of the distinct country exposures, a blended portfolio provides country and regional diversification.
EM Local Currency Bonds May Complement EM Hard Currency Bonds
|Modified Duration (Yrs)||6.76|
|Top 5 Countries||Weight (%)|
|United Arab Emirates||4.55|
|Modified Duration (Yrs)||4.66|
|Top 5 Countries||Weight (%)|
|Modified Duration (Yrs)||5.71|
|Top 5 Countries||Weight (%)|
Source: J.P. Morgan as of 12/31/2022. US EM Bonds represented by the J.P. Morgan EMBI Global Diversified Index. EM Local Bonds represented by the J.P. Morgan GBI-EM Global Core Index. Past performance is no guarantee of future results. The statistics above do not reflect those of any funds. It is not possible for an investor to invest directly in an index.
Investors who are primarily seeking to diversify their U.S. dollar denominated income portfolios may choose to overweight or only allocate to EM local currency bonds due to their low correlation. Similarly, investors taking a tactical view on waning U.S. dollar strength may also choose a heavier tilt towards local currency bonds.
Why might now be a good time to consider adding exposure to EM local currency bonds?
We believe there are several reasons that EM local currency bonds may be attractive now. First, emerging markets generally exhibit better fundamentals versus developed markets, on average, in terms of factors such as debt-to-GDP ratio and expected economic growth. This can provide support to local currencies, and the higher yields of emerging markets make them all the more compelling.
Second, EM central banks were far ahead of the Federal Reserve and other developed markets central banks in hiking rates to get ahead of inflation. Most hiked aggressively, and many countries are now seeing inflation moderate. This has resulted not only in high nominal rates of interest, but also high real yields and that also provides support for local currencies. It also gives EM central banks room to cut rates if needed to boost economic growth, which may also provide support to investors.
Third, after several years of negative returns as the U.S. dollar strengthened, we believe there are reasons EM local currencies may show more strength ahead. They remain undervalued relative to historical levels despite a recent increase in valuations. The China re-opening also has the potential to have a positive impact on many local currencies. We believe the reversal of zero-COVID policies, which took many investors by surprise, will benefit global growth (a positive for emerging markets generally) and in particular, commodity exporters. Commodity sensitive currencies, such as the Brazilian real, Peruvian sol and Colombian peso, may benefit.
How can investors access EM local currency bonds?
The VanEck J.P. Morgan EM Local Currency Bond ETF (EMLC) seeks to track the price and yield performance of the J.P. Morgan GBI-EM Global Core Index (GBIEMCOR), which comprises bonds issued by emerging market governments and denominated in the local currency of the issuer. EMLC is the largest and most liquid ETF providing access to the local currency sovereign bond market, according to Bloomberg as of 12/31/2022.
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1 Source: Morningstar as of 12/31/2022. EM Local Sov represented by the J.P. Morgan GBI-EM Global Diversified Index. US Aggregate represented by the ICE BofA US Broad Market Index Index. US Treasury represented by the ICE BofA US Treasury Index.
2 Source: Morningstar as of 12/31/2022. EM Local Sov represented by the J.P. Morgan GBI-EM Global Diversified Index. EM USD Sov represented by the J.P. Morgan EMBI Global Diversified Index. US HY Corporate represented by the ICE BofA US High Yield Index. Global Aggregate represented by ICE BofA Global Broad Market Index. US Equity represented by the S&P 500 Index. EM Equity represented by MSCI Emerging Markets Index.
3 Source: J.P. Morgan, MSCI as of 12/31/2022.
J.P. Morgan GBI-EM Global Index: tracks bonds issued by emerging markets governments and denominated in the local currency of the issuer.
J.P. Morgan GBI-EMG Core Index: tracks bonds issued by emerging markets governments and denominated in the local currency of the issuer. The weighting scheme provides additional diversification by more evenly distributing weights among the countries in the index. Countries are capped at 10% and floored between 1% to 3%.
J.P. Morgan GBI-EM Global Diversified Index: tracks emerging markets local government bonds that are accessible by most foreign investors. The weighting scheme provides additional diversification by more evenly distributing weights among the countries in the index. Countries are capped at 10%.
J.P. Morgan EMBI Global Diversified Index: tracks USD-denominated emerging markets sovereign bonds.
J.P. Morgan EMBI Global Diversified Index: tracks USD-denominated emerging markets sovereign bonds. The weighting scheme provides additional diversification by more evenly distributing weights among the countries in the index.
J.P. Morgan CEMBI Broad Index: tracks USD-denominated emerging markets corporate bonds.
ICE BofA Global Broad Market Index tracks the performance of investment grade debt publicly issued in the major domestic and eurobond markets, including sovereign, quasi-government, corporate, securitized and collateralized securities.
ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index: is comprised of U.S. dollar-denominated bonds issued by non-sovereign emerging markets issuers that are rated below investment grade and that are issued in the major domestic and Eurobond markets.
ICE BofA US High Yield Index: is comprised of below-investment grade corporate bonds (based on an average of Moody’s, S&P and Fitch) denominated in U.S. dollars. The country of risk of qualifying issuers must be an FX-G10 member, a Western European nation, or a territory of the U.S. or a Western European nation.
ICE BofA US Corporate Bond Index tracks the performance of US dollar denominated investment grade rated corporate debt publicly issued in the US domestic market.
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.
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