Emerging Market Debt: Hard Currency for Hard Markets
Against a challenging backdrop for fixed income, emerging market debt is one area where investors can take on some risk. High yields and portfolio diversification help to make this a compelling exposure within fixed income. However, given persistent US dollar strength, a hard currency approach to emerging market debt makes sense for the near term.
The challenging backdrop for fixed income investors persists. Two themes in the Q2 Bond Compass revolved around defensive positions – remaining short duration, protecting from inflation using TIPS. The third theme looked at how to add some risk with emerging markets (EM). High yields, the cheapness of local currency exposures and the fact that many of the EM central banks had already tightened policy to combat high inflation created some assurances that local markets were further through the process of returning to a more normal policy regime than developed markets.
However, the USD continues to defy gravity and this has caused a notable drag on performance for local currency bonds. For instance, for the JP Morgan EM GBI Global Diversified Index, the returns from currency have been -4.6% for this quarter to date versus -3.2% for price returns.1
For those investors who cannot see an imminent catalyst for a weaker USD, then exposure to hard currency EM debt can offer an alternative option to increase the yield and diversify the portfolio. The SPDR® ICE BofA 0-5 Year EM USD Government Bond UCITS ETF has several advantages:
Defensive duration positioning: Maturity constraints mean that the option-adjusted duration on the ICE BofA 0-5 Year EM USD Government Bond ex-144a Index is just 2.55 years.2 This is less than half that of the JP Morgan EMBI Global Diversified Index and should provide a degree of protection in the event that markets suffer another leg higher in yields.
Historically high yields: Despite the short duration of this EM strategy, it packs a punch when it comes to yield with a yield to worst of 5.68%. Aside from the squeeze higher in yields at the onset of the COVID crisis, this is the highest yield in more than 10 years (see chart below). Spreads to US Treasuries have also widened out to 310bp. Over the last 10 years, visits into the 300bp-plus area have been rare and, aside from during COVID, short lived.3
Diversity of issuers: The ICE BofA 0-5 Year EM USD Government Bond ex-144a Index has 58 country issuers. A deteriorating global growth outlook is not a constructive backdrop for EM debt but the worst-rated issuers are excluded. Within the ICE BofA 0-5 Year EM USD Government Bond ex-144a Index, just 3.4% of bonds are rated below single B, against 6.5% for the JP Morgan EMBI Global Diversified Index.4 This spread of issuers can assist in portfolio diversification: the ICE BofA 0-5 Year EM USD Government Bond ex-144a Index has had a correlation of just 12% to US Treasuries based off monthly data over the past 10 years despite being a USD-denominated asset. It is also worth noting that many nations that issue USD-denominated debt are commodity producers that receive a large proportion of their foreign earnings in US dollars.
Yield to Worst and Spread to Treasuries at Elevated Levels for ICE BofA 0-5 Year EM USD Government Bond ex-144a Index
Any hints that the COVID situation in China is easing may gradually cause risk appetite to start to return, which may then result in flows into EM bonds. However, with US inflation still coming in above expectations and the Federal Reserve in full tightening mode (and about to reverse course on its balance sheet expansion), there remain very real risks for most fixed income exposures.
By keeping duration risk low and limiting exposure to EM foreign exchange fluctuations, investors can receive a relatively high yield with fewer sources of risk than a traditional local currency exposure. For EUR-based investors who are uncomfortable with USD exposure, there is also the option of a EUR-hedged version of the ETF.
How to play this theme
Investors looking to access hard currency EM debt can do so with SPDR ETFs. To learn more about these ETFs, and to view full performance histories, please click on the fund names below.
2 Source Bloomberg Finance L.P. As at 29 April 2022.
3 Source Bloomberg Finance L.P. As at 6 May 2022.
4 Source: Bloomberg Finance L.P. using Bloomberg composite rating. As of 29 April 2022.
Diversification does not ensure a profit or guarantee against loss.
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