By Fran Rodilosso, Head of Fixed Income ETF Portfolio Management, and William Sokol, Director of Product Management
Emerging markets local currency bonds have been resilient amid extreme volatility in U.S. rates, recent banking troubles, and continued uncertainty around inflation and economic growth.
Where can fixed income investors look for relative stability amid extremely volatile U.S. rates, concerns about the banking system, and continued uncertainty on inflation and economic growth? Perhaps they should consider emerging markets local currency bonds, which have been resilient in this uncertain market environment. As shown below, the asset class has performed well through the mini-banking crisis (mini, at least so far) experienced in March, and has been one of the better performers year-to-date among various fixed income asset classes.
EM Local Currency Bonds Have Performed Well During Recent Banking Troubles
| MTD | YTD | 1-Year | |
| Local Currency EM Sovereigns | 3.11 | 4.14 | -0.18 |
| USD EM Sovereigns | 0.09 | 0.98 | -6.96 |
| US IG Corporates | 1.53 | 2.40 | -5.01 |
| US HY Corporates | -0.68 | 1.87 | -4.23 |
| US Treasuries | 2.43 | 2.56 | -4.53 |
| US Equities | 0.17 | 3.87 | -11.71 |
| EM Equity | 0.96 | 1.89 | -10.77 |
| EM Corporates | 0.24 | 1.63 | -2.71 |
Source: Morningstar as of 3/23/2023. Local Currency EM Sovereigns represented by the J.P. Morgan GBI-EM Global Diversified Index; USD EM Sovereigns represented by the J.P. Morgan EMBI Global Diversified Index; US IG Corporates represented by the ICE BofA US Corporate Index; US HY Corporates represented by the ICE BofA US High Yield Index; US Treasuries represented by the ICE BofA US Treasury Index; US Equities represented by the S&P 500; EM Equity represented by the MSCI EM Index; EM Corporates is represented by the J.P. Morgan CEMBI Broad Diversified Index. Past performance is no guarantee of future results.
Returns have been driven by both local rates (carry and a small decrease in average yield) as well as a modest positive impact from currency appreciation. Notably, the currency impact has been broad based, with 17 of the 20 currencies represented in the J.P. Morgan GBI-EM Global Diversified Index appreciating relative to the U.S. dollar as of March 28, 2023. The most notable exception is the Egyptian pound, which has lost 20% of its value this year following the adoption of a flexible exchange rate earlier this year.
Overall, the asset class has not performed in line with “risk-on” asset classes such as equities and high yield bonds. We believe this performance reflects EM local currency bonds relative insulation from the issues emanating out of developing markets which have troubled investors. Emerging markets local currency bonds are not directly impacted by U.S. interest rates, so the rapid rate hikes over the past year and volatility in U.S. bond yields have not had the same impact as on U.S. fixed income asset classes. Also, most EM central banks sharply raised policy rates shortly after the pandemic-driven turmoil in 2020, resulting in high real interest rates that have tamed inflation and provide room to ease policy if needed. The story is much different in developed markets, where inflation is still not convincingly under control. While emerging markets have maintained both fiscal and monetary policy discipline, the events following the U.K’s mini-budget proposal in 2022 illustrate that developed markets bonds are not immune to bond vigilantes (a bond trader who threatens to sell a large amount of bonds to protest policies of the bond issuer).—to the detriment of investors in those markets. Most recently, the bank runs in the U.S. and the failure of Credit Suisse have raised concerns about the banking sector’s health—a major concern if not contained. Encouragingly, emerging markets investors have largely shrugged off these concerns, at least for now. With that said, continued stress along with the Fed’s ongoing focus on inflation has implications on economic growth in the U.S. and globally, and is a risk that must continue to be monitored.
The turmoil in developed markets has also resulted in a recent increase in the yield pickup over emerging markets local currency bonds versus U.S. rates, following a steady decline this year as U.S. rates rose. With conditions tightening in the U.S. due to the distress in the financial sector, this rate differential may persist or increase, providing further support for the asset class.
Yield Pickup Over 5-Year UST Increased Sharply in March
Source: J.P. Morgan as of 3/28/2023. Yield Pickup represents the difference in yield between the on-the-run 5-year U.S. Treasury bond and the J.P. Morgan GBI-EM Global Diversified Index. Past performance is no guarantee of future results.
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Originally published 03 April 2023.
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