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A Diversification Play in Emerging Markets Debt

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A Diversification Play in Emerging Markets Debt

Written by: Fran Rodilosso

We believe one of the most attractive features of emerging markets debt, from a portfolio construction perspective, is the diversification potential it can provide. Within emerging markets debt, local currency bonds have historically provided the greatest diversification benefit compared to U.S. dollar-denominated emerging markets sovereign or corporate bonds, as measured by the segment’s relatively low correlation to other asset classes.

Emerging-markets Local Currency Bonds

This diversification advantage is driven by the two distinct sources of return that local currency bonds provide: return potential from foreign currency, as well as local interest rates that increasingly tend to be influenced primarily by local conditions rather than developed markets central banks.

The fourth quarter of 2018 provides a recent example of how emerging markets debt may help offset weakness experienced in other asset classes. As growth concerns mounted, credit spreads widened significantly and equity markets dropped. Emerging markets local currency bonds, as represented by the J.P. Morgan GBI-EM Global Core Index, returned 2.65%, during the quarter thanks to the substantial yields earned on the bonds as rates and currencies remained generally steady.1

Investors looking to diversify corporate bond or equity exposure, whose returns have been supported by accommodative central bank policy, may want to consider adding emerging markets local currency bond exposure.

With market expectations for further cuts to U.S. interest rates and potentially less support for the U.S. dollar, we believe the return potential of emerging markets local currencies may provide a boost to portfolio returns. Further, income-seeking investors may find the yields of over 6%—based on the J.P. Morgan GBI-EM Global Core Index—to be currently attractive, and the significant carry of the asset class may provide a cushion against potential weakness elsewhere in investors’ portfolios.2

Related: Time to Hedge Against Central Bank Uncertainty?

DISCLOSURE
1Source: J.P. Morgan, based on Q4 2018 performance.
2Source: J.P. Morgan, as of 9/30/2019.
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