Our analysis, both on a historical and forward-looking basis, shows that incorporating hard currency EMD into a global bond portfolio could increase the portfolio return with a similar return/risk ratio for a USD investor base. We think that investors should consider an allocation of 10–20% to hard currency EMD in their global bond portfolios (both USD hedged and unhedged) to enhance portfolio returns without significantly increasing volatility.
The case for incorporating local currency EMD into global portfolios is comparatively less compelling given currency volatility; therefore, taking a view on currency is an important consideration when investing in local currency debt. EM currencies are currently attractively valued from a long-term perspective relative to the US dollar — this provides a good entry point, but investors will still need to be aware of potentially high currency volatility. Investors who seek local currency EMD exposures could also consider investing in a blend of local currency and hard currency EMD to help mitigate the volatility in local currency EMD returns.
From a risk standpoint, USD-based investors need to understand and be able to tolerate potentially higher volatility and drawdowns in EMD relative to global aggregate bonds. We believe investors can take a strategic medium- to long-term investment horizon on EMD to ride out the cyclical downside of the asset class.