Currencies Are Slapping Emerging-Market Bonds

Rising Treasury yields have hammered local-currency EM bond funds

   

Currency movements are a fairly esoteric concept for most bond fund investors, but anyone who owns a fund invested in emerging-market bonds denominated in local currencies has been feeling the pinch lately.

Many emerging market currencies have plunged in recent weeks, adding to the already steep losses in emerging debt. Since April 30, the WisdomTree Emerging Currency Fund (CEW) — an ETF that invests in a basket of 15 emerging currencies — has lost 6.2%. The primary reason for this downturn is the prospect that the U.S. Federal Reserve will soon taper its quantitative easing policy, which has driven bond yields higher in the U.S.

Why does this matter for the emerging markets? Very simply, it’s a question of where investors can get the most bang for their buck.

When the 10-year note was yielding 1.6% back in May, an emerging-market bond yielding 4% was very attractive. Now, with yields near 3%, that 4% yield has become much less competitive. The result has been concerns about “capital flight” from emerging nations; or in other words, the departure of investor cash to greener pastures. And when cash leaves a country, it means investors must sell the currency — which in turn, drives the currency lower.

In some cases, this has prompted central banks to boost rates to defend their currencies, creating another layer of pressure on emerging bond markets.

The impact of currency fluctuations can be seen in the relative performance of two ETFs: iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB), which invests in bonds denominated in U.S. dollars, and Wisdom Tree Emerging Markets Local Debt Fund (ELD), which invests in local currency debt. Since April 30, ELD has fallen 13.3% and lagged the -11.5% return of EMB. In that same time frame, PIMCO Emerging Local Bond Fund (PELAX) has shed 14.76%, vs. a loss of 10.51% for PIMCO Emerging Markets Bond Fund (PAEMX).

Simply put, currency exposure has added insult to injury in an environment of already-dismal returns.

Local-currency funds are often presented to investors as having an “added source of long-term returns” (in the form of the long-term appreciation potential of emerging currencies), but that hasn’t been the case for two years now. Since mid-2011, emerging currencies have declined against the dollar, hurting anyone who has owned either these funds or a diversified emerging-market bond fund that has allocated a portion of its assets to local currency debt.

cew Currencies Are Slapping Emerging Market Bonds

Emerging currencies: two years past their peak

It’s in this latter group where investors may be experiencing the largest surprise. In response to the low-yield environment of recent years, many active managers have moved a portion of their portfolios out of  dollar-denominated government debt and into local currency bonds in order to pick up the added “carry.” While this approach added value in 2009 through mid-2011, it has been a liability since.

The selloff in emerging currencies has already been fairly dramatic, indicating that there might be a contrarian opportunity in local-currency debt — but only if Treasury yields stabilize or begin to fall. If the 10-year breaks through 3%, the asset class is likely to remain under pressure until the market settles down. It may therefore pay to be patient and keep an eye on how Treasuries behave in the coming weeks, rather than being too aggressive.

From a longer-term standpoint, local-currency emerging market bonds still have to prove it can hold up through financial-market turmoil without unduly punishing investors. Based on the events of the past few months, that time is still a long way off.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/2013/09/currencies-are-slapping-emerging-market-bond-fund-returns/.

©2014 InvestorPlace Media, LLC

Comments are currently unavailable. Please check back soon.