Why Should Investors Focus on Real Yield in Emerging Markets?

Real yields in emerging markets (or EM) have remained at compelling levels over the past few years even as they continued to decline in developed markets, and even as nominal yield levels declined in some EM countries. All else equal, currencies associated with higher real yields are generally expected to perform better than those with relatively lower real yields. And as the chart below shows, the real yield pictured in emerging markets is as attractive as it has been in five years.

Last summer we examined why real yields matter to emerging markets bond investors. Given the persistence of the real yield advantage, we believe it is worth revisiting why investors should focus on real yields.

Before we dive into the real yields that emerging markets are offering, let’s first make sure we understand what real yield is. Real yield is the nominal return on the bond investment, excluding the effects of inflation. We can calculate real yield by subtracting the inflation rate from the nominal yield of a bond. Inflation lessens the purchasing power of savings, so it’s essential to know the real yield on your investment.

Emerging markets (EMB)(EMAG)(IGEM) have risen tremendously in 2017, driven by strong fundamentals, strong economic growth, smarter policies, and rising commodity prices. The emerging debt market (PCY) was off to a shaky start in 2017, led by fears of trade wars, rising US interest rates, and a stronger dollar. However, the health of the global economy led to impressive performance in the emerging debt universe. The chart above by Alliance Bernstein shows some major emerging market economies that have stepped into expansion mode. Growth in these economies is expected to pick up.

Emerging market bonds in general offer diversified exposure along with higher real yields when you compare them to developed market bonds (IHY). To invest in the emerging market debt market, investors have a choice between local-currency sovereign bonds, hard-currency sovereign bonds, and hard-currency corporate bonds.  With local-currency sovereign bonds in particular, investors get exposure to local currencies in the EM market with higher real yields. Besides providing higher yield, these bonds offer currency appreciation.

Let’s move on to discuss how real yields for emerging market bonds can compensate for inflation risk in the next part of this series.