Fortify your 40% with emerging markets bonds

Apr 12th, 2021 | By | Category: Fixed Income

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By Fran Rodilosso, Head of Fixed Income ETF Portfolio Management at VanEck.

Fran Rodilosso, Portfolio Manager, Head of Fixed Income ETF Portfolio Management at VanEck.

Fran Rodilosso, Head of Fixed Income ETF Portfolio Management at VanEck.

Emerging market bonds historically do well in a rising interest rate environment. If interest rates are rising due to higher growth prospects — as opposed to a “taper tantrum” — emerging markets bonds may do particularly well.

This makes sense, given that rising US growth tends to lead to higher imports from emerging market countries, higher capital flows, and generally “risk-on” conditions. GDP is, after all, the denominator under which everything from corporate debt service to individual consumer consumption is based.

Credit quality should improve during periods of rising economic growth, and we believe the US looks set for a lot of growth. In fact, the US is on track to potentially grow faster than China in 2021, in our view!

The only reason to worry, traditionally, would be a Federal Reserve looking to take the punchbowl away too quickly, and we don’t expect to see that.

Of course, the month or two during which US interest rates first rise to accommodate this higher growth — as is happening now — is painful for all bonds. This is the simple math of duration multiplied by yield change. The year so far has followed that math, as emerging markets bonds have gone down in line with their duration times the US yield. Spreads haven’t widened, in other words. But what will happen once the bonds have absorbed this initial price rise? What is the longer-term effect of the higher yields that they pay and the improving economic conditions?

Emerging markets bonds have historically done well! Look at the two charts below, which show emerging markets debt performance during the past two reflationary periods (2004-2007 and 2015-2019). Both of these show what happened through a bunch of interest rate hikes by the Fed (which you can see in the light blue staircase line). In the 2004-2007 reflation, emerging markets local currency was up 60% and emerging markets hard currency was up 30%; in the 2015-2019 reflation, both were up 30%.

Reflation Is good for emerging markets bonds

Source: VanEck.

Source: VanEck.

Emerging markets local currency can be particularly attractive during these periods, as you can see from how well it did during the first reflation example (Note: Risks can occur). Emerging markets economies tend to benefit from US twin deficits (fiscal deficits plus current account deficit) — the US demands more goods from the emerging markets, particularly commodities. This historically benefits emerging markets currencies and weakens the US dollar, which kind of makes sense. If we’re sending US dollars into these economies to buy flat glass or auto components, that obviously bids up their own currencies. The chart below shows a sense of what can happen to the US dollar when the US engages in extremely stimulative policy, which it is doing today. The dollar falters! This is another example of how rising rates, if they are a function of better growth, can be fantastic for emerging markets bonds.

USD falters amid extremely stimulative policy

Source: VanEck.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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