EMLC: Question and Answer

Emerging markets in general moved much quicker than the U.S. and other developed markets to increase rates to stay ahead of inflation, which has resulted so far in higher nominal and real yields. In addition, emerging markets local currency investors could benefit from a more substantial level of income that is not eroded by loss of purchasing power (through a potentially weaker currency) as well as the potential for rate cuts to stimulate growth if needed. In this Q&A, we answer frequently asked questions about investing in emerging markets local currency bonds.

• How big is the market for emerging markets local currency bonds?
• Why do countries issue bonds in local currency?
• What are the benefits of investing in EM local currency bonds?
• What drives the risk and return of EM local currency bonds?
• Are EM local currency bonds a replacement for hard currency EM bonds?
• Why might now be a good time to consider adding exposure to EM local currency bonds?

How big is the market for emerging markets local currency bonds?

The emerging markets local currency bond market is substantial in size, and larger than many investors who are new to the asset class may realize. EM local currency bonds comprise nearly 60% of the investable emerging markets debt universe and is over 2.5x the size of the U.S. dollar denominated, or “hard currency,” EM sovereign market. However, nearly 90% of U.S. mutual fund and ETF assets are in hard currency EM bonds, suggesting that investors may be under-allocated to this asset class based on its size. Exposure in global bond benchmarks is also generally low or non-existent, so many investors are not getting exposure to this asset class through global bond funds.

EM Local Currency Represent Nearly 60% of the EM Debt Universe

Source: J.P. Morgan as of 31/12/2022. EM USD Sovereign represented by J.P. Morgan EMBI Global Index. EM Local Sovereign represented by J.P. Morgan GBI-EM Global Index. EM USD Corporate represented by J.P. Morgan CEMBI Broad Index. Past performance is no guarantee of future results. It is not possible for an investor to invest directly in an index.

The size of the market overall, and the development of individual local markets over the past several decades, has resulted in deep and liquid markets for many countries’ local currency bonds. Local investors such as banks, pension funds and insurance companies have helped drive active secondary market trading, along with increased offshore investor interest and more recently, an increase in trading activity through electronic trading platforms.

Why do countries issue bonds in local currency?

Issuing local currency denominated bonds is an option that many emerging markets have increasingly chosen over the past few decades. There are several reasons for this. First, demand has been increasing from both international investors as well as a growing local investor base in many countries, which has helped boost liquidity.

Second, local currency debt can help make a country more resilient against external shocks in terms of its ability to service its debt. Although hard currency debt may appeal to offshore investors due to the lack of direct currency risk, it can be more costly for the sovereign issuer, if the value of the dollar appreciates relative to their currency. Accordingly, investors in hard currency debt may be taking on higher credit risk in exchange for lower direct EMFX risk. This can be a particular concern in risk-off periods or if an individual country begins to encounter stress. In such a situation, international investors may reduce their exposure to the country, which will generally reduce the value of the local currency (as investors sell local assets) and increase the cost of funding. As a result it becomes more expensive to service hard currency debt. In the worst case, the sovereign may need to seek emergency funding or may even default.

Local currency debt, on the other hand, is much more insulated from these dynamics. Although existing investors may see the value of their holding decline as yields increase and the local currency depreciates, the issuer’s ability to service the existing debt is not as impacted by the value of the currency relative to the U.S. dollar. That is not to say that default cannot occur in local currency debt, particularly in unique circumstances such as what happened with Russian debt in 2022. However, generally speaking, the issuer bears less currency risk and as a result is better insulated from external shocks.

What are the benefits of investing in EM local currency bonds?

Generally, the investment case for emerging markets local currency bonds comes down to yield and diversification benefits within a broader portfolio. The asset class provides a significant yield pickup over both U.S. investment grade corporates and global bonds. Although the yield is somewhat lower than U.S. high yield bonds and hard currency sovereign bonds, the local currency universe is primarily investment grade, so should be compared to other asset classes through that lens. Versus other high quality fixed income asset classes, local currency bonds could be attractive in terms of yield.

EM Local Currency Bonds Offer Yield Pickup vs. U.S. IG and Global Bonds

Source: VanEck, Bloomberg, J.P. Morgan, ICE Data Indices, LLC. Data as of 31/12/2022. US HY is represented by the ICE BofA US High Yield Index. EM LC Sov is represented by the J.P. Morgan GBIEM Global Core Index. EM HY Corp is represented by the ICE BofA Diversified HY US Emerging Markets Corporate Plus Index. EM USD Sov is represented by the JPM EMBI Global Diversified Index. EM Corp is represented by the J.P. Morgan CEMBI Broad Diversified Index. US IG Corp is represented by the ICE BofA US Corporate Index. US Agg is represented by the ICE BofA US Broad Market Index. Global Agg is represented by the ICE BofA Global Broad Market Index. Past performance is no guarantee of future results. Index returns are not fund returns, and do not reflect management fees or brokerage expenses. It is not possible for an investor to invest directly in an index.

Largely due to the EMFX exposure, local currency sovereign bonds exhibit low correlation to U.S. dollar denominated asset classes. EM local currency bonds are less directly impacted by U.S. monetary policy and the movement of U.S. Treasury yields. Accordingly, the correlation between EM local currency bonds and U.S. Treasury bonds over the past decade is 0.10, compared to a 0.90 correlation between U.S. Treasuries and U.S. aggregate bonds¹. This means that the returns of the asset class may offset poor returns in other asset classes in a given year. For example, 2022 was a very difficult year for most U.S. fixed income asset classes, but EM local currency bonds outperformed U.S. aggregate bonds by approximately 3% during the calendar year. Please note, that past performance is no guarantee of future results. EM local currency bonds also exhibit a lower correlation to “risky” asset classes such as high yield bonds and U.S. equities versus hard currency emerging markets bonds.²

Emerging markets local currency bonds can also provide issuer and regional diversification within a portfolio. Compared to the hard currency emerging markets bond universe, the universe of local currency bond issuers is distinct. Generally, to be able to issue in the global market in a local currency, an issuer will have more established legal and regulatory systems, larger economies, higher credit ratings and more developed local capital markets. In addition, compared to emerging markets equities, the regional exposure of local currency bonds is significantly different, with exposure to Asia, Latin America and emerging Europe ranging from 23-36%, versus nearly 80% Asia exposure in the broad emerging markets equity benchmark³.

What drives the risk and return of EM local currency bonds?

The risk and return of EM local currency bonds is driven by two distinct factors: local interest rates and changes in the value of the currency. The local rates component includes both carry, or the amount earned from holding the bond (i.e. the yield), as well as price appreciation or depreciation as local interest rates change. As mentioned above, yields on emerging markets local currency bonds have historically been significantly higher than other investment grade fixed income asset classes. And for the international investors, although the value of local currency bonds will be impacted by changes in local rates, changes in the developed market bond yields will not have a direct effect.

The second component of return, local currencies, is unique to local currency denominated bonds compared to hard currency bonds or other U.S. dollar denominated fixed income asset classes, thus providing diversification benefits within a portfolio. Historically, this component of return has tended to be a bigger driver of volatility, including to the downside. For example, EMFX returns have been negative in 2020, 2021 and 2022 amid relentless U.S. dollar strength, and significantly and negatively impacted total returns in those years. Generally speaking, the most painful years of the past decade for the asset class were a result of EMFX depreciation, not duration, and local rates generally contributed positively to returns in most years. Interestingly, however, in years such as 2016, 2017 and 2019, in which the asset class experienced strong returns, EMFX was not the primary driver and in two of those years contributed only a negligible amount to total return.

Although some investors view emerging markets local currency bonds as primarily a play on the strength of the U.S. dollar, the appeal of the asset class could also ley largely in the less volatile returns from the relatively high level of carry. Further, strengthening local currencies (or a weakening dollar) are not a condition for attractive returns, which can be achieved in periods with U.S. dollar stability.

Currencies and Local Rates Drive EM Local Currency Returns

Source: VanEck, J.P. Morgan. Chart is based on the J.P. Morgan GBI-EM Global Core Index. Data as of 31/12/2022. Past performance is no guarantee of future results. Index returns are not fund returns, and do not reflect management fees or brokerage expenses. It is not possible for an investor to invest directly in an index.

Are EM local currency bonds a replacement for hard currency EM bonds?

EM local currency bonds could have a role in a diversified global bond portfolio as either a complement or replacement to hard currency EM bonds, depending on an investor’s objective. There are reasons to consider an allocation to both asset classes, given the different risk and return profiles. As shown below, hard currency bonds have a much higher tilt towards high yield issuers, resulting in a higher overall yield. Issuing in dollars gives countries the ability to issue longer duration bonds, so a mix of the two asset classes provides exposure to both U.S. rates duration as well as local interest rates. And because of the distinct country exposures, a blended portfolio provides country and regional diversification.

EM Local Currency Bonds May Complement EM Hard Currency Bonds

Source: J.P. Morgan as of 31/12/2022. US EM Bonds represented by the J.P. Morgan EMBI Global Diversified Index. EM Local Bonds represented by the J.P. Morgan GBI-EM Global Core Index. Past performance is no guarantee of future results. The statistics above do not reflect those of any funds. It is not possible for an investor to invest directly in an index.

Why might now be a good time to consider adding exposure to EM local currency bonds?

We believe there are several reasons that EM local currency bonds may be attractive now. First, emerging markets generally exhibit better fundamentals versus developed markets, on average, in terms of factors such as debt-to-GDP ratio and expected economic growth. This can provide support to local currencies, and the higher yields of emerging markets make them all the more compelling.

Second, EM central banks were far ahead of the Federal Reserve and other developed markets central banks in hiking rates to get ahead of inflation. Most hiked aggressively, and many countries are now seeing inflation moderate. This has resulted not only in high nominal rates of interest, but also high real yields and that also provides support for local currencies. It also gives EM central banks room to cut rates if needed to boost economic growth, which may also provide support to investors.

Third, after several years of negative returns as the U.S. dollar strengthened, there could also be reasons for EM local currencies may show more strength ahead. They remain undervalued relative to historical levels despite a recent increase in valuations. The China re-opening also has the potential to have a positive impact on many local currencies. We believe the reversal of zero-COVID policies, which took many investors by surprise, will benefit global growth (a positive for emerging markets generally) and in particular, commodity exporters. Commodity sensitive currencies, such as the Brazilian real, Peruvian sol and Colombian peso, may benefit.