Emerging Markets Have Stung Some Core Bond Funds

Emerging-markets debt is quite common within global, multisector, and nontraditional bond funds. It’s less well known, however, that emerging-markets bond allocations have become more common in core bond funds. In recent years, scores of intermediate-bond funds have sported high-single-digit to low-teens stakes in emerging-markets debt (that includes both U.S. dollar-denominated bonds as well as the much more volatile issues denominated in local currencies). Although the typical fund in the category has a mere 1% invested in emerging-markets debt and many funds have no allocation, today’s levels are still a good deal higher than a decade ago when the largest stakes came in around 5%.

After two strong years, the JPM EMBI Global Diversified Index, which contains emerging-markets bonds denominated in U.S. dollars, slid by 5% in 2018’s first half. But investors in local-currency bonds fared worse (the JPM GBI-EM Global Diversified fell by 6%) as the U.S. dollar rallied and most emerging-markets currencies sank, especially in the second quarter. The period is a good reminder why manager skill matters when incorporating emerging-markets bonds, and especially currencies, into core fixed-income funds. To illustrate, the Argentine peso fell by a staggering 35% versus the U.S. dollar in the second quarter of 2018 over concerns about the country’s significant external financing needs. The Turkish lira came under pressure (down 17% versus the U.S. dollar) following President Erdogan’s re-election, and investors were skittish about the Brazilian real (down 14%) given the resignation of Petrobras’ CEO and the central bank’s decision to keep rates on hold.

These exposures hurt some core bond funds, especially during the second quarter, including a handful of our Morningstar Medalists. The team at

Silver-rated

Gold-rated

The team at Bronze-rated

Emerging-markets bonds and currencies are generally meant to be minor drivers of return for core bond funds. These managers have a lot of other levers to pull to offset air pockets like we’ve seen this year, but it’s crucial to invest with teams that have the depth and breadth of support required for emerging-markets debt investing.

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