After a very poor performance in 2022, emerging market bonds have started to rebound. This could be a good time for U.S. investors to at least consider a nibble.
iShares J.P. Morgan USD Emerging Markets Bond
exchange-traded fund (ticker: EMB), which invests solely in dollar-denominated debt, lost 18.6% last year, including interest payments. But as of Wednesday, it was up 1.9% in 2023, with a yield of 6.7%.
Nominal emerging market bonds denominated in local currencies yield about 7%, on average, according to J.P. Morgan Asset Management. Those denominated in hard currencies, mainly the dollar, yield about 8%.
The macroeconomic backdrop for emerging markets overall looks reasonable, though far from certain, depending in part on how China’s economic reopening unfolds. Still, “we are not seeing major recessions across emerging markets,” says Pramol Dhawan, head of emerging markets portfolio management at Pimco.
The central banks in countries such as Brazil, Chile, Mexico, and Hungary started aggressively raising short-term interest rates before those in developed markets did. “They took real yields to a high enough level where they stemmed the outflows and can start attracting inflows once again,” says Dhawan.
Another potential tailwind for these bonds is the dollar. The WSJ Dollar Index is 8% below its 52-week high, set in late September. Dhawan, who helps run the
Pimco Emerging Markets Local Currency and Bond
fund (PELAX), says the choice between dollar-denominated bonds and local-currency debt “largely depends on your view on the dollar. Our view is that the dollar is rich by about 10%.”
The strength of the dollar has been intertwined with the Federal Reserve’s aggressive rate-hiking as it tries to curtail inflation. Whenever the U.S. central bank finishes tightening, EM bonds could benefit as capital flows shift.
“Emerging markets prefer a weaker dollar or, at a minimum, a stable dollar,” says Iain Stealey, international chief investment officer of the global fixed-income team at J.P. Morgan Asset Management.
Local-currency bonds, which have grown much faster than dollar-denominated debt over the past two decades, offer sharp contrasts. With dollar-based debt, “you’re taking a view on the credit quality of the emerging market country,” says Stealey. But a local-currency EM bond, which has credit risk, as well, trades in part on a particular nation’s central bank policy. Plus, there’s currency risk.
A weaker greenback can help U.S. investors in emerging market local-currency debt, in part because its returns aren’t eroded as much as it would be with unfavorable exchange rates.
Stealey and his colleagues prefer local-currency debt, partly because some of it offers attractive inflation-adjusted, or real, yields. For example, Brazil’s 10-year government paper yields about 13%, well above the 6% inflation rate there, he says, adding that real yields in the U.S. are much lower at roughly 1%.
There’s also the added sweetener of local-currency appreciation if the dollar continues to slip.
But yields vary markedly across emerging markets, Stealey points out. Though 10-year government bonds in Poland generate about 6%, that country’s consumer price index grew at a 17.2% annual clip in January—meaning the securities have a negative real yield.
China, which is reopening its economy after a long shutdown triggered by the onset of Covid in early 2020, has a 10-year government bond yield of about 2.9%—not far above where it was a year ago. Says Stealey: “It was quite an attractive investment this time last year, but it’s not looking as attractive today.” B
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