Rebounding commodities prices and a weaker dollar have been cited as driving factors for several well-known asset classes and sectors this year. Previously downtrodden emerging markets currencies are soaring this year with plenty of help from the two aforementioned catalysts.
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As a result, emerging markets bond denominated on local currencies have some tailwinds after being viewed as one of the most vulnerable asset classes to a stronger dollar and higher U.S. interest rates. Some fixed incomes are likely happy with the returns safe U.S. government bond exchange-traded funds are sporting this year.
Tumbling Treasury yields will do that, but look at the VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (Market Vectors Emerging Mkts Local ETF (EMLC)). That ETF is up nearly 10 percent year-to-date while sporting a 30-day SEC yield of almost 5.9 percent. EMLC follows the JPMorgan GBI-EMG Core Index (GBIEMCOR), which tracks local currency-denominated emerging markets debt.
Digging Deeper Into EMLC
With 20 percent of its combined weight allocated to bonds denominated in the Brazilian real and Mexican peso, EMLC is levered to higher commodities prices and the Fed's reluctance to boost interest rates.
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However, the Federal Reserve's sentiment may have changed. The Fed appears to be taking a more dovish stance and the market is now expecting fewer rate hikes this year. Some immediate results could include a pullback in the U.S. dollar and the re-emergence of a risk-on appetite. These tailwinds have been strengthened by the first quarter rebound in commodity prices and the prospect of pro-growth political reform in several EM countries, according to a recent VanEck note.
Although emerging markets bonds have come under pressure in recent years with major developing economies such as Brazil suffering credit downgrades, EMLC is not a significant risk from a credit perspective as 71.6 percent of the ETF's holdings carry investment-grade ratings. Just over 9.5 percent of EMLC's 218 holdings are not rated.
EMLC may be seen as vulnerable to higher U.S. rates, but the ETF's duration is just 4.83 years with a yield to worst of 6.39 percent. EMLC has some other advantages as well.
Local currency EM bonds have exhibited low historical correlations with other segments of the fixed income market, especially core U.S. investment grade sectors, as shown below. Local currency EM bonds have also historically provided higher yields versus other EM bond sectors, with an investable universe that tends to be skewed more towards higher quality issuers. For example, 84 percent of local currency EM government bonds were rated investment grade at the end of the quarter, versus 63 percent of those denominated in hard currencies, as measured by the BofA Merrill Lynch Emerging Markets External Sovereign Index, added VanEck.
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