Emerging-Markets Local Debt Could Finally Be Poised to Rebound

A version of this article was published in the December 2021 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting the website.

Emerging-markets local debt has been among the worst-performing fixed-income sectors in recent years, and 2021 was no exception. Last year, the JPMorgan GBI-EM Global Diversified Index, which tracks local-currency emerging-markets sovereign debt, lost a whopping 8.9%; meanwhile, the JPMorgan EMBI Global Diversified Index, which tracks U.S.-dollar-denominated emerging-markets sovereign and quasi-sovereign debt, lost a more modest 1.8%. Rising U.S. rates and inflation concerns as well as slowing Chinese growth and issues in the Chinese property sector contributed to the sell-off in emerging-markets debt. However, the strength of the U.S. dollar relative to many emerging-markets currencies explains why local currency did so much worse.

Despite the recent turmoil in emerging-markets local bonds, they could be an attractive option based on valuations. At the end of 2021, the emerging-markets local-currency bond Morningstar Category had a median SEC yield of 5.0%, which topped the median high-yield bond fund's SEC yield of 4.0%. In addition to the attractive yield, many emerging-markets central banks have proactively raised real rates (interest rates adjusted for inflation) at a much faster pace to their developed-markets peers, as many emerging-markets central banks have been less willing to test if current inflation will prove transitory. As a result, the difference between emerging-markets real rates and developed-markets real rates is at a 15-year high. This combined with supportive oil dynamics, continued growth recovery, and peaking inflation could lead to a rebound in emerging-markets local debt.

Still, emerging-markets bonds carry amplified risks alongside their lofty yields and can move more in line with equities than developed-markets debt. Political, macroeconomic, and regulatory developments can all impact credit risk and introduce volatility. Sovereign issuers are a mix of investment-grade and junk-rated. Local-currency-denominated emerging-markets debt is particularly volatile given its potent currency risk. Given the elevated risks, emerging-markets local bonds are best suited for a supporting role in a portfolio.

For investors seeking a pure-play emerging-markets local-debt strategy, Pimco Emerging Markets Local Currency and Bond PELBX offers exposure to local rates and currencies. However, we give the fund a Morningstar Analyst Rating of Neutral because its emerging-markets debt team has struggled to distinguish itself.

Another way to gain exposure is through a wide-ranging fund with a meaningful allocation to the sector. Gold-rated Western Asset Core Plus Bond WACPX, which resides in the intermediate core-plus bond category, sports a well-diversified portfolio focused on the investment-grade space but typically carries more emerging-markets local debt than peers. In recent years, the team has not hedged its local-currency exposure back to the U.S. dollar, which can create more volatility. Fortunately, the strategy has a deep and experienced team to lean on. While its emerging-markets local-debt bet has faced some challenges in recent years, the team's investment theses have a solid track record of panning out: The institutional shares' 10-year 4.5% annualized return through December 2021 blew past its typical category peer.

Dodge & Cox Global Bond DODLX, which has an Analyst Rating of Gold, is a world-bond fund with a tilt toward corporate bonds. The experienced managers here build a concentrated, high-conviction portfolio with a notably high corporate credit stake, which typically represents half of the portfolio. The bulk of its emerging-markets allocation (29% of assets in December 2021) is in local-currency sovereign debt (20%). The managers tend to keep foreign-currency exposure to around 20% on average. Its helping of emerging-markets local debt has helped it serve investors well over time. From its May 2014 inception through December 2021, it outpaced all peers.