Three Reasons to Allocate to EM Bonds Now

Emerging market central banks responded quicker to inflation and remain in better shape financially than developed markets, and EM bonds may add resilience to a bond portfolio in the current market.

The past several years have been characterized by rising rates and emerging risks in global bond markets, after nearly a decade and a half of declining yields and low volatility in many developed markets. Below we explore why investors should consider allocating to emerging market (EM) bonds in the current market environment. View here for a PDF version of this blog.

1. EM Bonds May Help Insulate a Bond Portfolio from DM Risks

Developed markets rates have risen sharply since pandemic-era lows, and bond investors in these markets are on track for a third straight year of losses. Central banks have been aggressively hiking rates, after falling behind the curve on inflation. More recently, long term yields have begun to rise to levels not seen in 15 years, as the market begins to price in a “higher for longer” environment amid persistent inflation, still hot economic data and rising fiscal problems. An eventual Fed rate cut would likely occur when recessionary risks are high, which would likely be adverse for developed markets corporate bonds, which are still very tight. In other words, a turn in rates is not the turn in risk. In contrast, emerging market central banks generally got ahead of inflation in the early days following the pandemic. Inflation has been declining, and real rates in many markets remain attractive, which has provided support to local currencies along with rising commodity prices. The lack of irresponsible fiscal policy in EM stands in stark contrast to what is playing out in developed markets.

Given these diverging backdrops, it is not surprising that emerging markets bonds have been more resilient compared to both US and global investment grade aggregate bonds given the turmoil in those markets over the past few years. Given the long-term nature of the risks that continue to emanate from developed markets, we believe there is a strong case to allocate to EM bonds to make a bond portfolio more resilient.

EM Bonds Have Weathered the Storm Better

Source: Morningstar, as of 30/9/2023. US Agg is represented by the ICE BofA US Broad Market Index; Global Agg is represented by the ICE BofA Global Broad Market Index; EM Bonds is represented by 50% J.P. Morgan EMBI Global Diversified/50% J.P. Morgan GBI-EM Global Diversified.

2. Emerging Markets Have Lower Debt

Notwithstanding China’s more recent policy direction, emerging markets, in general, have moved much more quickly to increase interest rates compared to the U.S. and other developed market (DM) rates in order to stay ahead of inflation. For investors, this fundamental backdrop means less issuance and rolling over of debt, a favorable supply/demand dynamic that should help support EM bonds. In addition, if needed, EM central banks can hike interest rates without bankrupting the government (unlike the challenges we saw in the United Kingdom or even the US during its budget showdowns).

Debt Levels of EM Countries Are Relatively Attractive

General Government Gross Debt, % GDP

Source: VanEck Research; Bloomberg LP. Data as of October 2023.
Past performance is not indicative of future results. Please see important disclosures and definitions at the end of the blog.

3. EM Has Independent Central Banks

The primary focus of EM central banks is to focus on controlling inflation, and they do this by maintaining high real interest rates. For investors, the result has been not only higher nominal yields but higher real yields. The benefits to EM local currency investors are a more substantial level of income that is not eroded by the loss of purchasing power (through a potentially weaker currency). Additionally, if the central bank's actions are successful in controlling inflation, it can lead to a stronger and more stable economy.

EM Central Banks’ Focus on Inflation Means Higher Income for Investors

Real Policy Rates in EM and DM (%), 12m from now if current expectations for rates and inflation materialize

Source: VanEck Research; Bloomberg LP. Data as of 16 October, 2023.

Ex-Post Real Policy Rates in EM and DM, (%)

Source: VanEck Research; Bloomberg LP. Data as of October 2023.
Past performance is not indicative of future results. Please see important disclosures and definitions at the end of the blog.

The VanEck Emerging Markets Bond UCITS Fund is actively managed with the flexibility to invest in sovereign and corporate debt in hard and local-currency. The Fund’s broad universe and bottom-up, high active share approach drives the opportunity to potentially outperform the benchmark over a market cycle.