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Emerging Market Bonds: Can the Hot Start In 2017 Continue?

Key Points
  • Emerging market (EM) bond prices surged in the first quarter, benefiting from a softer U.S. dollar and reduced concerns about protectionist trade policies and additional Federal Reserve rate increases.

  • Historically, high yields and diversification benefits can be good reasons to include EM bonds in a portfolio for investors who can tolerate some volatility. However, EM yields now have declined versus U.S. Treasury yields while risks remain.

  • We consider EM bonds as part of the aggressive fixed income allocation, not as part of the core holdings.

Emerging market bonds were big winners among fixed income asset classes in the first quarter. The total return for the Bloomberg Barclays Emerging Markets USD Aggregate Bond Index rose an impressive 3.3%, compared with 0.8% for the Bloomberg Barclays U.S. Aggregate Bond Index. Bonds denominated in local currencies performed even better, returning 6.8%.

Much of the price gain this year represents a rebound from late 2016. The combination of higher U.S. interest rates, a strengthening dollar and the threat of U.S. trade tariffs weighed on EM bonds in the fourth quarter, but concerns about all three issues waned in early 2017.

Emerging market bonds rebounded in the first quarter

Source: Bloomberg, as of 3/31/17. Past performance is no guarantee of future results.

Why does the strength of the U.S. dollar and U.S. interest rates matter to EM bonds? For issuers of U.S. dollar denominated debt, a rise in the dollar may make it more costly to repay. While investors still receive interest and principal in dollars, the bond may selloff if there is concern about the issuer’s ability to pay. The impact on investors who purchase local currency EM debt is more direct. A rise in the dollar means investors would receive less interest and principal because of the reduced value of the local currency. 

Meanwhile, higher U.S. interest rates tend to draw investors toward U.S. Treasury bonds, which tend to be less risky than EM bonds.

Sentiment toward emerging markets shifted in the first quarter as it became clear that the path of Federal Reserve rate hikes would remain gradual and the implementation of pro-growth fiscal policies and protectionist trade policies might be delayed or possibly watered down. As the dollar slipped by about 3% from its 14-year peak in January and bond yields declined globally, the relatively high yields offered by emerging market bonds attracted investors.

Slim compensation for higher risk

While the yields on emerging market bonds are attractive relative to those in major developed market countries, valuations aren’t cheap. After the sharp rally, the average option-adjusted spread (OAS) of the Bloomberg Barclay’s Emerging Markets USD Aggregate Bond Index is roughly 270 basis points,¹ near the low set in 2013 before the dollar’s 20% rise. The narrow spread means investors aren’t getting as much compensation for the risks in EM bonds as they were a few months ago. Since EM bonds have historically been far more volatile than U.S. Treasuries, we think investors should be cautious about increasing exposure when the yield spread is so narrow.

The spread between EM bonds and U.S. Treasuries is below its four-year average  

Source: Bloomberg, as of 3/31/17. Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan.

Meanwhile, risks remain. The Fed is still on the path to raising interest rates, which could lead to a resumption of the U.S. dollar’s rally and reduce the attractiveness of EM bonds. During the dollar’s recent bull market from mid-2014 to mid-January 2017, EM bonds denominated in local currencies underperformed. As the table below shows, from the end of May 2014 through March 2017, local currency EM bonds produced a total return of -5.9%, compared with a positive 12.9% return for dollar-denominated EM bonds and 6.2% for the Bloomberg Barclays U.S. Aggregate Bond Index. The dollar’s appreciation against EM currencies was the major factor weighing on returns in local currency EM bond markets.

Local currency EM bonds underperformed during the recent U.S. dollar bull market

Source: Bloomberg, as of 3/31/17. Past performance is no guarantee of future results.

Political and economic risks in EM countries also make us cautious. The Trump administration recently announced steps to examine trade practices of countries with which the U.S. has its largest deficits, such as Mexico and China, with the threat of imposing trade restrictions. A slowdown in global trade can weigh disproportionately on EM countries because many rely on exports for much of their gross domestic product growth. Moreover, some of the largest issuers of bonds in the emerging market universe are sovereign governments facing political and economic challenges. Mexico has elections coming up this year and Brazil is encountering political challenges. South Africa’s economy is in turmoil and its bonds have been downgraded to below investment grade.

Neutral looks good to us

While we are cautious about EM bonds after the recent rally, we are not suggesting that investors reduce allocations. Our view is neutral. The historically high yields and diversification benefits of EM bonds are good reasons to include them in a diversified portfolio, for investors who can tolerate some volatility. We usually suggest no more than a 20% allocation to aggressive income investments within a fixed income portfolio.

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:

-          Call Schwab anytime at 877-338-0192.
-          Talk to a Schwab Financial Consultant at your local branch.

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