Emerging market (EM) bonds have performed strongly so far this year, as loose monetary policies in the developed world have driven yield-seekers into new markets.
We believe investors should be cautious as rising debt levels and slow global growth raise the risk of defaults or losses in the EM bond market.
EM bonds can provide diversification benefits, but we suggest investors have no more than a strategic allocation to such bonds.
After several years of mixed results, emerging market bonds—whether denominated in U.S. dollars or local currencies—have delivered positive total returns so far this year. The total return for the Barclays Emerging Markets USD Aggregate Bond Index is 12.6% this year, while the Barclays Emerging Markets Local Currency Government Index has delivered a 14.6% return.1
Those results have been driven by the downward shift in expectations about the pace of rate hikes by the U.S. Federal Reserve and very easy monetary policies in Europe and Japan. Returns from local-currency EM bonds have also received a fillip this year from high coupons and gains in EM currencies like the Brazilian real and Russian ruble. (Remember, gains in a foreign currency boost returns from that country’s bonds when they’re converted into U.S. dollars.)
With investors searching for income, the relatively high yields on EM bonds compared with those in other markets have begun to attract buyers. Inflows into EM bond funds have been strong in the past month. According to Morningstar, inflows to EM bond funds in July amounted to $2.8 billion, the largest monthly inflow ever recorded.
However, we would advise caution before joining the fray. First of all, currency fluctuations have actually been a problem for local currency bonds in recent years. They could also be an issue going forward as EM corporate borrowers have gorged on U.S. dollar-denominated debt in recent years. And, finally, EM bond prices may have been pushed to the point where they aren’t offering enough compensation for the risks involved.