Amid expectations that the Federal Reserve is nearing or at the end of its tightening cycle, bonds are rebounding in 2023. It remains to be seen if the Fed cooperates – there’s some chatter another pair of right hikes could be in the offing – the environment is improving for bonds and bond funds.
That’s particularly good news when considering 2022 was one of the worst years on record for aggregate bond strategies. Better still is the point that advisors’ search for viable fixed income assets need not be confined to the U.S. Believe it or not, that includes emerging market bonds, including those issued in local currencies.
Non-dollar-denominated debt issued by developing economies compensates investors for the perceived elevated risk with higher yields, but there’s more than meets the eye and the “more” can include quality and diversification benefits.
“The incentives between issuing local- or hard-currency debt also led to different geographical adoption of each approach. Certain countries, such as South Korea, Thailand, and the Czech Republic, have very little sovereign debt outstanding in U.S. dollars, as they prefer to issue in their local currencies. On the other hand, the local-currency debt of Middle East nations is mostly excluded from broad local-currency indexes at this point,” noted Morningstar analyst Lan Anh Tran.
EM Bonds Delivering for Clients
There are times in the bond market when the juice (more risk/volatility) is worth the squeeze (better returns and/or higher yields). Take the case of the J.P. Morgan GBI-EM Global Core Index.
Year-to-date, that gauge of 370 local currency issues is beating the widely followed Bloomberg Aggregate U.S. Bond Index by a margin of better than 3-to-1. Add to that, the upside generated by the J.P. Morgan GBI-EM Global Core Index is broadly sourced as bond issued by 17 of 20 constituent countries are pointed higher this year.
Speaking of diversification/reduced correlation benefits, that proposition has been on display this year as emerging markets debt are holding up nicely despite bank collapses in the U.S.
“Since March, investors have been reminded that financial sector stress is unique in its ability to impact broader markets, due to the risk of contagion, impact on the economy through credit availability, and potentially, the costs of a bailout. Such costs often historically have fallen on the public, and the impact to sovereign fiscal positions can be material,” according to VanEck research. “The failures of certain regional banks in the U.S., although they appear idiosyncratic and contained so far, have spooked domestic markets, but emerging markets (EM) have appeared insulated.”
Over the past 90 days – the period including the spate of U.S. bank failures – the J.P. Morgan GBI-EM Global Core Index is beating the Bloomberg Aggregate U.S. Bond Index by 260 basis points.
With EM Bonds, Sound Risk/Reward
Clients usually figure that developed market bonds have the better credit ratings and are therefore less risky. However, the U.S. is now on “credit watch negative” at Fitch Ratings and while a debt default here isn’t highly likely, it’s also worth noting the credit risk with EM bonds isn’t as high as many clients believe.
For example, the J.P. Morgan GBI-EM Global Core Index is more than 75% allocated to investment-grade bonds and more than 36% of that group is rated A, AA or AAA. There are other risks with EM debt for advisors to discuss with clients, but the good news is those issues aren’t of major concern at the moment.
“We believe the most likely impact to emerging markets would be from slower growth due to tightening of credit in the U.S. as regional lenders pull back, which is happening in the context of the Fed’s ongoing battle against inflation,” concludes VanEck. “In addition, general risk aversion and volatility has historically impacted ‘risk-on’ asset classes such as emerging markets, even though this has not been the case this year.”