We suggested underweighting emerging market bonds in November 2017 due to high valuations and rising risks associated with tighter monetary policy. Valuations have improved due to a selloff in EM bonds and currencies, but we still suggest staying underweight.
Valuations: Yields for EM bonds have risen in the past few months, widening the yield spread versus Treasuries, but investors still aren’t getting much compensation for the risk of further price and currency declines.
Risks: With the Federal Reserve and other major central banks moving ahead with plans to tighten monetary policy, the dollar is rebounding and real interest rates are rising, which could make it harder for EM companies and to finance their debt.
Our major theme over the past year is that investors should prepare for the “end of the era of easy money.” We anticipated that with the Federal Reserve and other central banks tightening monetary policy, the days when investors were willing to take large risks in exchange for small rewards would end. As yields on Treasuries rose, investors would begin to demand increasingly higher yields on riskier bonds, resulting in lower prices in those segments of the market. It appears that the process has begun.
Last fall, we singled out emerging market bonds in particular for risks and suggested underweighting the asset class. Recently, EM bonds have underperformed developed market bonds, as yields are moving higher and currencies are falling. While there are some one-off factors affecting the various countries, the overall result has been a selloff in most EM bonds and currencies.
Emerging market currency performance
Source: Bloomberg. Emerging Market World Currency Spot Return. Date range 4/13/2018-5/14/2018. Past performance is no guarantee of future results.
Even after the recent selloff, EM bond yields haven’t reached levels that we see as attractive on a risk/reward basis. Valuations still appear high. The yield spread of U.S. dollar-denominated EM bonds compared to Treasuries has moved up sharply to 2.7% in the past month, but remains below the post-financial crisis average of 3.3%.1
Emerging market bond spreads spike, but remain below post-financial crisis average
Source: Bloomberg Barclays Emerging Markets USD Aggregate Bond Index, monthly data as of 5/14/2018.
Note: The post-financial crisis average of 3.3% was calculated by using the date range of 6/1/2009 to 5/14/2018.
For countries and companies that have borrowed in U.S. dollars, further declines are possible. As the Fed hikes rates it’s likely that the U.S. dollar will continue to firm up, making the repayment of debt by foreign entities more expensive. Over the past decade, issuance of U.S. dollar-denominated debt by EM countries and companies has soared to over $1.2 trillion from just $220 billion,² leaving a large portion of the market vulnerable to a rise in the dollar. Argentina is running into this problem. Having issued a 100-year bond in U.S. dollars last year, the country is now having difficulty paying bondholders and has asked for help from the International Monetary Fund.
Debt issued in local currencies won’t face that problem, but there are other risks to consider. Demand is likely to ebb as U.S. rates rise. Also, investors, facing the prospect of being repaid in cheaper currency, are likely to demand higher yields, generally sending bond prices lower. Historically, EM local currency bonds have been more volatile while delivering lower returns than U.S. dollar-denominated bonds. The chart below illustrates that local currency EM bond returns have been almost twice as volatile as U.S. dollar-denominated EM bonds over the past five years, with significantly lower total annualized returns.
Source: Bloomberg Barclays Emerging Market Local Currency Index and Bloomberg Barclays Emerging Market USD Aggregate Bond Index, 5-year annualized standard deviation and total return. Data range used May 2013 to April 2018. Past performance is no guarantee of future results.
Today the yields on local currency EM bonds are below those of U.S.-dollar denominated EM bonds, so investors aren’t being compensated well for the potential for greater volatility and the heightened currency risk. Historically, local currency bonds have yielded about 14 basis points less than U.S. dollar-denominated bonds, but today the yields are almost 50 basis points lower. Investors in local currency EM bonds today are therefore facing lower relative yields compared to the past decade, but also the risk of falling currencies when the dollar is rising.3
The yield difference between USD-denominated and local currency EM bonds is about 50 basis points
Source: Bloomberg Barclays Emerging Market USD Aggregate Bond Index and Bloomberg Barclays Emerging Market Local Currency Government Bond Index, Yield to Worst. Monthly data as of 5/11/2018. Yield to worst is defined as the lowest potential yield that can be received on a bond without the issuer actually defaulting.
A number of other risks appear to be rising. Slowing growth in China raises risks for Asian emerging market countries that rely on exports to China. Also trade disputes and political uncertainty have been on the upswing from Mexico to Malaysia recently.
Overall, we still suggest maintaining an underweight allocation to EM bonds despite the recent rise in yields. Valuations are still not attractive on a risk/reward basis. With the Federal Reserve and other major central banks moving towards tighter monetary policy and rising political risks, we see the potential for EM bonds to continue underperforming core U.S. bonds.
1 Post-crisis average is from 6/1/2009 through 5/14/2018.
2 Source: BofA Merrill Lynch U.S. Emerging Markets Liquid Corporate Plus Index (EMCL). Monthly data as of 11/30/2017.
3 Average yield difference from 6/30/2008 through 5/11/2018.
What You Can Do Next
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
- Explore Schwab’s views on additional fixed income topics in Bond Insights.