Viktor Aheiev
The diverging performance of emerging markets local currency bonds in 2023 versus those in developed markets reflects the changing fundamental reality for fixed income investors.
U.S. bond yields have been on an upwards trajectory in recent weeks, with the 10-year Treasury yield up nearly 100 basis points (bps) from its lowest level of the year and reaching its highest level in approximately 16 years, as of August 15, 2023.
With multiple forces keeping U.S. rates high, and potentially pushing them higher, emerging markets (EM) bond investors may be assessing potential impacts.
It is notable that in this environment, EM local currency sovereign bonds have strongly outperformed other fixed income asset classes such as U.S. Treasuries (+700 bps), U.S. investment grade corporates (+500 bps) and even U.S. high yield corporate bonds this year (+38 bps).
Year-to-date Returns (as of 8/15/2023)
Source: Morningstar Direct as of 8/15/2023. EM Local Currency Sovereign is represented by the J.P. Morgan GBI-EM Global Core Index. US HY Corporates is represented by the ICE BofA US High Yield Index; EM USD Sovereign is represented by the J.P. Morgan EMBI Global Diversified Index; US IG Corporates is represented by the ICE BofA US Corporate Index; US Agg is represented by the ICE BofA US Broad Market Index; US Treasuries is represented by the ICE BofA US Treasury Index. Past performance does not guarantee future results.
Higher U.S. rates are generally positive for the U.S. dollar, and the dollar has rallied approximately 3.7% against its developed market trading partners since mid-July.
However, for the year the dollar is flat against this same group of currencies while EM currencies (EMFX) are up by a modest 0.4% versus the dollar. The 6.8% return on EM local currency bonds, therefore, has been driven primarily by local interest rates rather than currency movements.
Such has been the case in many past years of EM local outperformance. The YTD return has come from both high carry and a general decrease in emerging markets bond yields, in stark contrast to the upwards trend in developed markets rates.
This recent behavior is a good example of the potential diversification benefits emerging markets local currency bonds can provide within a global fixed income allocation.
Given the diverging paths of U.S. and emerging markets bonds yields, the yield differential is now below the historical average. However, we believe EM local currency bonds remain attractive relative to developed markets fixed income because of the starkly different fundamental landscape.
Most emerging markets raised rates aggressively following the onset of COVID-19 in order to get ahead of inflation, and many have been successful in doing so. The result has been both high nominal yields and high real yields, allowing investors to benefit from both high levels of carry as well as support to the local currency.
Brazil, for example, has seen inflation drop from over 9% in 2022 to a year-over-year rate of 4% as of July. Rates have come down significantly this year, with the 10-year government yield dropping by approximately 130 bps, but remain high even after adjusting for current and expected inflation.
In fact, Brazil’s 10-year nominal bonds still yield more than 11%. Meanwhile, the Brazilian real has appreciated against the U.S. dollar by 6% this year. Policy reforms and the potential to benefit from elevated commodity prices provide further support for the country’s local fixed bonds.
Although each country is unique and there are certainly exceptions to the generally positive fundamentals in emerging markets (e.g. China and Turkey), we believe Brazil provides an interesting contrast to developed markets. The Fitch Ratings downgrade of the U.S. credit rating earlier this month highlighted the long-term impact that lack of fiscal discipline and political uncertainty can have on any country’s credit risk.
The experience in the United Kingdom last year provided an even more dramatic example. We believe the diverging performance of emerging markets local currency bonds this year versus those in developed markets reflects this changing fundamental reality for fixed income investors.
Index descriptions:
J.P. Morgan GBI-EM Global Core Index is comprised of bonds issued by emerging market governments and denominated in the local currency of the issuer.
ICE BofA US High Yield Index tracks the performance of U.S. dollar-denominated below investment grade corporate debt publically issued in the U.S. domestic market. Qualifying securities must have a below investment grade rating. Original issue zero coupon bonds, 144a securities, both with and without registration rights, and pay-in-kind securities, including toggle notes, qualify for inclusion. Eurodollar bonds, taxable and tax-exempt U.S. municipal, warrant-bearing, DRD-eligible and defaulted securities are excluded from the Index.
J.P. Morgan EMBI Global Diversified Index is comprised of U.S. dollar-denominated Brady bonds, Eurobonds, and traded loans issued by emerging markets sovereign and quasi-sovereign entities. The index weighting methodology limits the weight of countries with larger debt stocks.
ICE BofA US Corporate 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.
ICE BofA US Treasury Index tracks the performance of US dollar denominated sovereign debt publicly issued by the US government in its domestic market.
Important Disclosures
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Investments in emerging markets bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets. Emerging markets bonds can have greater custodial and operational risks, and less developed legal and accounting systems than developed markets.
All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future results.
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