Tread Carefully in Emerging Market Bonds

Why Emerging Market Bonds May Be Overvalued

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Emerging market bonds have become extremely popular over the past several years. With U.S. and European interest rates near record lows, investors have sought out riskier bonds in order to bolster yields for income portfolios. In fact, the iShares JP Morgan USD Emerging Markets Bond ETF (EMB) took in more than $4.3 billion so far this year. The problem is that emerging markets may have become over-extended with the threat of rising U.S. interest rates.

In this article, we will take a look at why investors may want to exercise caution when considering an investment into emerging market bonds.

Currency Risk on the Rise

Emerging market bonds have been strong performers, but some bonds may be significantly riskier than others going forward. Currency-hedged bonds are denominated in U.S. dollars or hedged against declines in a local currency relative to the U.S. dollar. By contrast, local currency bonds are denominated in a local currency with investors running the risk of losses when converting bond payments back into U.S. dollars — a key risk if the dollar were to rise in value.

The U.S. dollar tends to increase in value when interest rates rise and fall in value when interest rates move lower. With the Federal Reserve considering a rate hike by year-end, investors may want to tread carefully before purchasing local currency bonds. These bonds could fall in value if the U.S. dollar rises in value relative to the local currency, since it would become more expensive for investors to convert local currencies back into U.S. dollars.

Increasing Credit Risk

Currency-hedged emerging market bonds aren’t immune from the effects of a rising dollar. While investors may not lose out on currency conversions, the dollar’s rise could significantly increase credit risk. These increases in risk could, in turn, lead to lower bond prices and higher bond yields as investors adjust their risk-reward calculations.

While higher yields may be good news for some, those holding bonds will experience losses from price depreciation.

Corporate borrowers in emerging markets have dramatically increased their U.S. dollar debt in recent years thanks to low interest rates. Unfortunately, many of these companies generate revenue in local currency, which means that a rising dollar could make their debt a lot more expensive to repay if the dollar rises. These dynamics are especially troublesome given the sluggish global economic growth and dimming outlook for the future.

Despite these greater credit risks, emerging market bond yields have been relatively tame compared to developed market bond yields. Dollar-denominated emerging market government bonds trade at just over a 3% premium to comparable U.S. Treasury bonds, which is lower than the 4% average over the past 16 years. The same is true for corporate bonds that trade with just a 2.5% premium – in line with historical long-term trends.

Alternatives to Consider

Investors have a number of different options when it comes to finding yield in today’s low yield environment, including both equities and bonds.

Those looking to build a diversified bond portfolio may want to consider a mix of U.S. high quality bonds like Vanguard Total Bond Market ETF (BND), U.S. corporate bonds like iShares Investment Grade Corporate Bond ETF (LQD), international bonds like Vanguard International Bond ETF (BNDX), and a small portion of emerging market bonds like Vanguard Emerging Market Bond ETF (VWOB).

Others might consider dividend-focused equity funds for yield.

In general, it’s a good idea to maintain a diversified portfolio to avoid any concentrated risks that can have an outsized impact on overall returns.

The Bottom Line

Emerging market bonds have become increasingly popular as investors seek yield in today’s low yield environment. Unfortunately, the strong demand may have led to mispriced risk, particularly when it comes to the possibility of higher U.S. interest rates. Investors may want to exercise caution when investing in emerging market bonds given these dynamics and instead consider looking into income-focused equities or other bonds.