One of the hottest corners of the fixed income market is positioned to continue delivering upside as the U.S. dollar remains lethargic and bond investors continue embracing higher-yielding opportunities. Emerging markets debt is on a torrid pace of performance and, when it comes to exchange-traded funds, adding new assets.
For example, the iShares J.P. Morgan USD Emerging Markets Bond ETF (NASDAQ: EMB), the largest emerging markets bond fund of any variety, is up more than 9 percent year to date. EMB and rival dollar-denominated emerging markets bond funds are benefiting from the dollar's status as a disappointing developed market currency and the lack of a significant increase in U.S. Treasury yields.
Of course, yield helps. Even with its impressive year-to-date gain, EMB still sports a solid 30-day SEC yield of 4.4 percent. That is a lot better than what investors find on Treasuries or aggregate bond ETFs, which are usually heavily allocated to Treasuries and mortgage-backed securities.
In the eyes of some market observers, emerging markets bonds have the wind at their backs when it comes to delivering more capital appreciation for investors.
“We like selected EM debt for income and potential price appreciation amid low inflation and subdued currency volatility in the emerging world,” said BlackRock in a recent note. “EM debt also gleans support from synchronized global growth, commodity prices and global investor thirst for yield.”
Another important catalyst is the capacity for emerging markets central banks to lower interest rates, something that off the table in much of the developed world.
“Unlike developed market (DM) central banks, many EM counterparts have room to cut rates given a backdrop of steady growth and subdued inflation,” said BlackRock. “This should lead to a further narrowing of interest rate differentials versus the rest of the world as the Federal Reserve leads its DM peers in normalization. We expect relative price outperformance in EM debt as a result.”
In addition to EMB, another idea to consider is the iShares J.P. Morgan EM Local Currency Bond ETF (NYSE: LEMB). As its name implies, the iShares J.P. Morgan EM Local Currency Bond ETF holds debt denominated in local currencies, meaning it can benefit when the dollar is weak. For the added risk of embracing emerging markets currencies, investors get a higher yield of 5.55 percent with LEMB.
“Stronger EM currencies have boosted the performance of EM local-currency debt this year,” said BlackRock. “We see the U.S. dollar appreciating only modestly and gradually—and not diluting the EM investment case. So what are the main risks? A stalling of global growth momentum, a yield spike caused by slowing monetary stimulus, or a rapidly resurging dollar.”
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