As emerging markets matured over the last couple decades, many countries began issuing debt, denominated in their respective local currency, rather than US dollars. This has created a valuable sub-asset class worth more than 3 trillion US dollars, alongside US dollar-denominated emerging markets debt. Given projections for US deficit growth and the potential for sustained US dollar weaknesses, we believe now is a good time for investors to consider their allocations to this large and growing segment of the emerging markets debt universe.

In our view, EM local currency bonds can offer an attractive risk-reward trade-off for investors seeking a high level of current income and US dollar diversification. Countries that issue local currency debt tend to have independent central banks, developed yield curves, and investment-grade credit ratings.

Here are four reasons to consider investing in EM local currency bonds in diversified portfolios.

1. The universe for emerging markets debt has changed significantly over the last 20 years

Local currency bond issuance has increased significantly since the early 2000s and is now the predominant issuer base within the asset class. It also represents the greatest degree of depth within fixed income emerging markets and benefits from a broad investor base consisting of foreign investors, local governments, pension funds, banks and other domestic investors.

2. Local currency bonds provide US dollar diversification

Emerging markets currencies allow investors to diversify their US dollar exposure within a broader portfolio. Moreover, diversified allocations to these currencies can provide an opportunity to benefit from potentially stronger global economic growth, which has historically coincided with appreciation in their value relative to the US dollar.

3. Emerging markets local currency bonds can provide a high level of current income

Emerging markets local currency debt has at times provided a higher yield than its US dollar-denominated counterpart. Both have provided a meaningful pickup in yield over US Core bonds. A recovery in global economic growth could be supportive of the asset class and may benefit emerging markets currencies in particular over the longer term.

4. A weaker dollar typically benefits emerging markets local currency bonds

Given relatively low yields in the US coupled with “twin” deficits (fiscal and current account deficits) that are expected to grow, it is reasonable to believe the US dollar is likely to move into a period of longer-term decline. This could meaningfully benefit emerging markets bonds and currencies. Although both local currency and dollar-denominated emerging markets bonds have historically provided strong results when the US dollar was weak or weakening, local currency debt has typically added significantly more value.

 

1. Source: J.P. Morgan. EM dollar sovereign bonds represented by J.P. Morgan EMBI Global Bond Index; EM local currency sovereign bonds represented by J.P. Morgan GBI-EM Broad Index. Data as of 31 December 2020.capitalgroup.com

2. Source: Bloomberg, J.P. Morgan. US Dollar FX is represented by the Bloomberg Dollar Spot Index; Emerging Markets FX is represented by the J.P. Morgan Emerging Local Index. Data as of 31 March 2021.

3. Source: J.P. Morgan, Bloomberg. US dollar EM debt represented by J.P. Morgan EMBI Global Diversified Index; local EM debt represented by J.P. Morgan GBI-EM Global Diversified Bond Index; US Core debt represented by Bloomberg US Aggregate Index. Data as of 31 March 2021.

 

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.