Not-so-fun fact: 10-year Treasury yields are up almost 114% for the six months ending April 7. To say that's making life difficult on advisors and income-needy clients is an understatement.
Moreover, some experts believe 3% 10-year yields are possible. That's saying something because yields on benchmark government debt close at 1.65% on April 7. As things stand today, the U.S. economy can likely withstand if not support a move to 3% by 10-year Treasuries. The 40% in traditional 60-40 portfolios? Probably not.
As advisors well know, the bedrocks of the fixed income sleeves of 60-40 portfolios are usually aggregate bond exposures with heaping helpings of U.S. government bonds, some allocations to municpal bonds – also an area with depressed yields – and small doses of investment-grade corporate debt.
Too often, client portfolios aren't adequately exposed to international bonds, which usually sport higher yields than U.S. equivalents. And if those portfolios aren't holding much in the way of ex-US developed market debt, they are almost certainly underweight emerging markets bonds. That shouldn't be the case, particularly in this environment.
Surprising Bond Allies for Advisors
In the first couple of months of viscous yield swings, such as the current move by 10-years, few if any corners of the bond market go unscathed. However, if that move higher is the result of economic growth and not a taper tantrum, markets historically work through it and fixed income winners emerge.
One of the winners in such a scenario is emerging markets debt. Not only do bonds from developing economies offer higher yields, but the asset class is a surprisingly sensible allocation in today's climate.
“This makes sense, given that rising U.S. growth tends to lead to higher imports from emerging market countries, higher capital flows, and generally 'risk-on' conditions. GDP is, after all, the denominator under which everything from corporate debt service to individual consumer consumption is based,” according to VanEck research.
Adding to the case for emerging markets is that relation is here and in the prior two reflationary eras – 2004-2007 and 2015-2019 – developing world debt – both dollar-denominated and local currency – topped Treasuries and domestic IG corporates.
In fact, local currency bonds are attractive in reflationary environments. Plus, that group offers higher yields. The J.P. Morgan GBI-EM Global Core Index, which is comprised of local currency bonds, yields 4.94%, or almost 90 basis points higher than the dollar-denominated J.P. Morgan EMBI Global Core Index.
“Emerging markets economies tend to benefit from U.S. twin deficits (fiscal deficits plus current account deficit)—the U.S. demands more goods from the emerging markets, particularly commodities,” notes VanEck. “This historically benefits emerging markets currencies and weakens the U.S. dollar, which kind of makes sense. If we’re sending U.S. dollars into these economies to buy flat glass or auto components, that obviously bids up their own currencies.”
More Reward Without Huge Risk
Local currency bonds aren't for all clients. The couple that's in their 80s can probably do without the added risk, but these bonds can be useful for clients with long runways to retirement, even 10 years or less.
Plus, the added risk mentioned above isn't startling. The J.P. Morgan GBI-EM Global Core Index is about 40% investment-grade with another 43.43% not rated.
Obviously, there's currency risk. If the dollar strengthens, the allure of bonds issued in other currencies declines. However, the Federal Reserve is engaging in stimulative monetary policy, which is depressing the dollar, setting the stage for upside for emerging markets bonds.
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