Continued volatility – focus on quality: Higher quality assets may be more resilient in periods of market volatility. One area within emerging markets that may allow investors to be more defensive is U.S. dollar denominated investment grade sovereign emerging markets bonds. This sector may allow investors to avoid the volatility that can be associated with emerging markets local currencies, while maintaining high credit quality which may benefit investors if spreads begin to widen. Further, these bonds provide a significant yield advantage over other investment grade fixed income sectors such as U.S. corporate bonds.
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Although these bonds may exhibit sensitivity to changes in interest rates, they could also benefit if rates retreat from their recent highs. This could occur if it appears that Trump may not be able to deliver on the growth-oriented agenda he has promised, resulting in lower inflation expectations.
You have two options when it comes to investing in emerging market bonds (EMB) (EMAG) (IGEM)—hard currency bonds and local bonds. The benefit associated with investing in investment-grade bonds is that it reduces the impact of currency risk as well as volatility associated with emerging market bonds (PCY) (EMLC).
Local currency bonds provide investors with two distinct sources of return: local bond yields and potential currency appreciation. But they work well when the local currency strengthens or the dollar weakens.
For most of 2016, the local currency bond outperformed its developed market (IHY) counterparts and other emerging market bonds. That was followed by a sell-off in emerging market currencies after Donald Trump’s surprise win. Despite the potential headwinds, local currency bonds returned 1.9% in December and 9.9% in 2016.
Brazil, Russia, and South Africa were the strongest contributors in 2016 with significant gains from both local rates and currencies. Hard currency sovereign bonds returned 1.3% in December, ending the year with a rise of 10.2%, as you can see in the graph below.
According to Goldman Sachs analysts Andrew Matheny and Sara Grut, “Goldman is shifting its preference to investment-grade debt from high yielders because economies with lower leverage and more local-currency denominated liabilities are likely to be less impacted by strength in the dollar.”
In the next part, we’ll take a look at the opportunities in local currency bonds.