Emerging-Market Bonds: Are Returns Worth the Risk?

Emerging-market local-currency bonds have rallied sharply since last October, along with other risky segments of the global bond market. With global economic growth stable or improving, inflation pressures easing, and central banks cutting interest rates or approaching rate cuts, there is room for the trend to continue.

In a benign economic environment, investors are often willing to stretch into riskier segments of the bond market in search of higher yields. However, emerging-market (EM) local-currency bonds typically are more volatile and carry higher risks than developed market bonds. Navigating the market can be challenging, and many investors may prefer to use funds or other professional management strategies when investing.

The EM local-currency bond universe is diverse and changes over time. It contains bonds issued by governments and government agencies, as well as corporations in their home currencies. There are two broad types: bonds denominated in U.S. dollars, euros, or currencies of other major developed countries—also known as "hard-currency" bonds—and "local-currency" bonds, which are denominated in the issuer's home currency. Yields on hard-currency EM bonds tend to be higher than on local-currency bonds because some lower-rated issuers aren't able to find buyers for their home-currency debt due to a history of depreciation and/or default. Local-currency bonds typically offer somewhat higher yields, offered by somewhat less-risky issuers. Yields reflect the rates set by the issuers' central banks. All else being equal, policy rates tend to be higher in emerging-market countries than in developed markets.

There are different indices that track these markets. If you are buying a fund or index-tracking exchange-traded fund (ETF), it's important to know what's in the underlying index because there can be large variations in yields, duration, and risks, and those differences can affect the return of the investment. In our view, the risk/reward in the hard-currency EM group doesn't look especially attractive. Yields are relatively low compared with developed market yields.

We see greater opportunity in the local-currency segment of the market. We are using the Bloomberg Emerging Markets Local Currency Liquid Government Index for this article. It represents government bonds issued by countries that are deemed EM by either the World Bank or International Monetary Fund. The index limits exposure to any one country to 10%. It does not include corporate debt, and is unhedged. The current makeup of the index represents bonds from 18 countries, with four countries near the 10% cap.

Note that we favor these types of indexes because they cap exposure to any one country's bonds. As the chart below illustrates, without those caps, it can be harder to get a diversified portfolio. For example, a country like China is a large issuer in this category and can end up dominating an index.

The cumulative total return of the EM local-currency index has outperformed both the Global Aggregate Bond Index and the US Aggregate Index since last fall.

As the chart illustrates, returns can be volatile due to fluctuations in interest rates, currency values, inflation expectations, and political developments. However, for investors with a higher risk tolerance, we believe local-currency EM bonds could deliver attractive returns over the next year. In the past, performance has been strongest during periods of positive global economic growth, easing monetary policies among major central banks, and falling inflation. Those conditions appear likely to materialize over the next year.

We expect most major central banks, led by the U.S. Federal Reserve, to begin cutting their policy rates later in the year as inflation pressures continue to ease. Meanwhile, global economic growth appears likely to improve from its relatively sluggish pace of the past year. EM countries, which are often major exporters that benefit most from an upturn in global economic activity and trade, have tended to benefit from those conditions in the past.

Moreover, several EM central banks have already started cutting interest rates, raising the prices of their bonds—which move inversely to yields—due to falling inflation after the supply-side shocks of the past few years. With a yield-to-worst of 6.2%, the index's average yield has fallen by about 60 basis points (or 0.6%) from its recent peak, but it's well above the 3.74% yield of the Bloomberg Global Aggregate Bond Index. Moreover, the average duration of the EM index is 5.4 years compared to the Global Agg's duration of 6.6 years, making it somewhat less sensitive to interest rate changes.

EM local-currency debt can be a good source of diversification within a fixed income portfolio. Returns tend to have a low correlation with U.S. Treasuries. However, they do have somewhat higher correlations with developed market bonds, corporate bonds, and U.S. equities. Default is also a risk and something that should be considered when investing in EM bonds. Consequently, it makes sense to limit exposure to a relatively small portion of a portfolio.

One of the biggest drivers and risks for EM local-currency bonds is the movement in the dollar. After more than a decade of appreciation, the U.S. dollar's strength has entered a more stable phase. Ever since the Federal Reserve indicated its rate-hiking cycle has ended, the dollar has shown limited movement against most EM currencies. The prospect of a stable-to-weaker dollar makes holding EM currency bonds more attractive, as it reduces the potential for currency losses to offset the yield advantage. A strong dollar, especially if it's driven by a negative shock that causes a flight to safety, such as during the pandemic in 2020, would be a major negative factor for these bonds.

Among the opportunities in the fixed income markets in 2024, local-currency EM bonds may be one to consider for investors with a higher risk tolerance. The relatively high yields and likelihood of rate cuts by global central banks have created a tactical investment opportunity. In addition to high yields, EM local-currency bonds can provide diversification and the potential for capital gains. However, the risks in this asset class tend to be high, so the amount of money allocated should be limited.