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
| Total Returns as of 3/28/23 | ||||
| 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
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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J.P. Morgan GBI-EMG Core Index: tracks bonds issued by emerging markets governments and denominated in the local currency of the issuer. The weighting scheme provides additional diversification by more evenly distributing weights among the countries in the index. Countries are capped at 10% and floored between 1% to 3%.
J.P. Morgan GBI-EM Global Diversified Index: tracks emerging markets' local government bonds that are accessible by most foreign investors. The weighting scheme provides additional diversification by more evenly distributing weights among the countries in the index. Countries are capped at 10%.
J.P. Morgan EMBI Global Diversified Index: tracks USD-denominated emerging markets sovereign bonds. The weighting scheme provides additional diversification by more evenly distributing weights among the countries in the index.
J.P. Morgan CEMBI Broad Diversified Index: tracks USD-denominated emerging markets corporate bonds. The weighting scheme provides additional diversification by more evenly distributing weights among the countries in the index.
ICE BofA US Corporate Investment Grade Index: tracks the performance of US dollar denominated investment grade rated corporate debt publicly issued in the US domestic market.
ICE BofA US Treasury Index tracks the performance of US dollar denominated sovereign debt publicly issued by the US government in its domestic market.
ICE BofA U.S. High Yield Index: tracks the performance of U.S. dollar-denominated below investment grade corporate debt publicly 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.
MSCI Emerging Markets Equity Index: represents the performance of emerging markets equities.
S&P 500 Index: consists of 500 widely held common stocks covering industrial, utility, financial, and transportation sector.
An investor cannot invest directly in an index. Returns reflect past performance and do not guarantee future results. Results reflect the reinvestment of dividends and capital gains, if any. Certain indices may take into account withholding taxes. Index returns do not represent Fund returns. The Index does not charge management fees or brokerage expenses,
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There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer duration fixed-income securities and during periods when prevailing interest rates are low or negative.
Emerging Market securities are subject to greater risks than U.S. domestic investments. These additional risks may include exchange rate fluctuations and exchange controls; less publicly available information; more volatile or less liquid securities markets; and the possibility of arbitrary action by foreign governments, or political, economic or social instability.
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