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  Western Asset Core Plus Bond  (WACPX), which has a Morningstar Analyst Rating of Gold, added rather aggressively to its non-U.S. currency stake, including emerging markets, in late 2016. That helped the fund in 2017 as the U.S. dollar slumped, and, going into 2018, the fund held 7% in emerging-markets bonds as well as an overall non-U.S. currency stake of 10% based on the team’s view that the U.S. dollar would continue to weaken. A few small currency shorts (euro, Australian dollar, yuan) helped over the period, but the fund was still hit harder than most because of single-digit stakes in the Mexican peso, Brazilian real, and Russian ruble, as well as smaller positions in other slumping currencies. The fund’s emerging-markets debt and currency stakes hovered around the same levels as of mid-2018.

Silver-rated  PGIM Total Return Bond (PDBZX) has owned a smattering of emerging-markets sovereigns, local-currency bonds, corporates, and select currencies for the past few years. It had a total of 5% in emerging-markets debt at the end of 2017, but that level was up to 8% as of mid-2018, and its allocation to longer-duration Brazilian local rates was particularly painful over the period.

Gold-rated  PIMCO Total Return (PTTRX) held around 13% in emerging-markets debt coming into 2018, a big decline from two years earlier when it accounted for around one fourth of assets. This seemingly large exposure also included a sizable stake in Treasury bills that were hedged back to the U.S. dollar, which lowers the risk. This year, however, the fund felt some pain from exposure to Brazilian sovereigns as well as small currency allocations in the Argentine peso and Russian ruble. The fund’s emerging-markets debt exposure sat at 17% as of June 30, though it accounted for just 5% of its duration-weighted exposure.

The team at Bronze-rated  AB Income (ACGYX) had started to bring down its emerging-markets debt stake in late 2017 given its rockier outlook for the sector. However, its 9% stake as of May 2018 was still significant compared with many core bond funds, with key weightings in Brazil, Mexico, and Argentina as well as small exposures in the Malaysian ringgit, Mexican peso, and Russian ruble.

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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