Local currency bonds offer an interesting longer-term opportunity for three reasons: They offer higher yields, they can deliver better performance better when rates are rising (since rate increases are a positive for currency performance), and they provide investors with a way to diversify out of U.S. dollars and gain access to currencies with better long-term appreciation potential.
Investors are considering emerging debt for a long-term investment will therefore want to take a good look at this space. Still, even though this segment has the potential to outperform dollar-denominated debt, it will also track funds such as EMB and PCY on the downside if emerging market bonds do indeed begin to weaken. As is the case with high yield, there’s no rush to invest.
Active Management Can Add Value Here
One takeaway from the discussion above is that “emerging-market bonds” is no longer a monolithic asset class dominated by dollar-denominated government debt. At a time in which emerging-market debt is vulnerable to subpar returns, this might be a time when investors are better off looking at an actively managed mutual fund rather than an ETF focused on one specific area of the market.
Morningstar’s sortable list of emerging-market bond funds is available here without a subscription. The top fund for the five-year period is TCW Emerging Markets Income I (TGEIX), which has delivered a five-year average annual return of 13.79% and outpaced the 8.91% category average.
While it isn’t advisable to pick a fund based solely on its past performance, the TCW fund — which yielded 5.59% as of March 31 — has a “go anywhere” strategy that allows it to invest in corporates or sovereigns, and both dollar-based debt and local currencies. At this stage of the rally in emerging-market bonds, this type of flexibility is attractive relative to an index-based approach.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.
Emerging debt has delivered stellar past performance, and the potential long-term return potential of certain segments is very attractive. This kind of potential is especially compelling at a time in which funds tied to the Barclays Aggregate are only yielding 1.5% to 1.6% — barely enough to stay ahead of inflation.
Right now, however, the near-term outlook for emerging isn’t particularly attractive with sovereign yields where they are. Exercise patience if you’re thinking of investing in emerging market bonds.