Emerging Market Bonds: Where Do We Go From Here?

The U.S. dollar is wreaking havoc on emerging market bonds

Investors that were early to identify the attractive valuations following the volatility in emerging market bonds in early 2014 are still sitting atop a pile of gains, yet in recent months new investors haven’t experienced the same steady uptrend.

bondsPartly due to the slack in the credit markets domestically, bonds in emerging markets have largely moved sideways in a 2% range over the past few months. The seemingly endless uptrend in the U.S. dollar has been weighing heavily on retail interest for foreign assets, even those that are in fact already denominated in U.S. Dollars.

While it’s impossible to know just how far the dollar can climb, or how long emerging market bond volatility will persist, I believe keeping them on your radar with a plan to add during the recent consolidation could pay off in the intermediate term.

Judging by the recent price action in two of the largest U.S.-dollar-denominated emerging market bond index ETFs — the iShares Emerging Market Bond Fund (EMB) and the Powershares EM Sovereign Debt Portfolio (PCY) — it’s clear both funds are mired with indecision.

A Closer Look at Emerging Market Bonds

From a technical perspective, the lows established in the broad channel dating back to mid-June have not been breached on the downside, further contending that EM bonds could have firm support. However, in the near term, it appears that channel is narrowing, which can lead to break down or break out, and in turn cause a fast move as a result of some unknown catalyst.

The funds have largely worked off any intermediate overbought tendencies, as each is toggling above and below its 50-day moving average.

From a fundamental perspective, EM bonds seemingly have everything going for them, including a decently buoyant equity market, a stable interest rate environment and election cycle fatigue that has largely passed. Furthermore, EM bonds still present better value and yield when compared to corporate securities issued in the U.S. with similar credit ratings.

The biggest crux to the stellar fundamental backdrop is the fear over a potential global slowdown. Nor are EM bonds helped by the perceived tension of the U.S. Federal Reserve fully unwinding its quantitative easing program, which has been a driving force for investment in both domestic high yield and EM fixed income assets over the last several years.

However, both scenarios are pure speculation since growth rates still look healthy for many EM nations, and it’s still too early to know the long-term follow-on effects of a domestic credit market without QE.

From an observational standpoint, EMB and PCY have returned roughly 9% this year (including dividends), which puts them near the top of the heap for credit-weighted indices. However, to see the real effects the U.S Dollar has levied on local currency indexes, the iShares Local Currency EM Bond Fund (LEMB) is essentially flat on the year. All else being equal, an 8.5% divergence from currency factors alone is significant.

How to Play Emerging Market Bonds

From a strategy perspective, aggressive investors who believe the recent run-up in the U.S. Dollar may be ending could start a position in LEMB at current price levels. That position would account for an upward bet on EM currencies and fixed income prices.

On the other hand, aggressive investors that want to sidestep the currency dynamics altogether and seek a higher yield than EMB or PCY offer could opt for the iShares Emerging Markets High Yield Bond Fund (EMHY), with its current 30-day SEC yield of 6.5% and a mix of both corporate and sovereign issues.

Although both EMHY and LEMB have underperformed to a greater extent in recent months, a shorter-term portfolio opportunity could see an investor overweighting the two funds. That way, you further diversify existing core holdings in EMB or PCY with hopes of a rally into year-end.

Finally, conservative investors eager to add lower-risk EM exposure could opt for the newly launched DoubleLine Emerging Markets Low Duration Bond Fund (DELNX). DELNX lowers volatility by investing in primarily EM corporate issues with durations of less than 3 years, thereby reducing much of the risk that interest rate fluctuations add.

DoubleLine has a lot of experience in EM Bonds, and if you’re fretting over the DELNX’s lack of experience, look at the Luz Padilla’s other EM bond fund the DoubleLine Emerging Market Fixed Income Fund (DLENX), which currently ranks in the top 98th percentile of all EM bond funds in 2014.

No matter how you decide to play EM bonds, there are many great options to increase your portfolio’s yield and total return once the driving forces at work begin unfold.

Michael Fabian is Managing Partner and Chief Investment Officer of FMD Capital Management. FMD Clients own EMB and PCY.

Learn More: Why I love ETFs, And You Should Too


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