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Emerging-Markets Local Debt Could Finally Be Poised to Rebound

Here's three ways to gain exposure.

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A version of this article was published in the December 2021 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting the website.

Emerging-markets local debt has been among the worst-performing fixed-income sectors in recent years, and 2021 was no exception. Last year, the JPMorgan GBI-EM Global Diversified Index, which tracks local-currency emerging-markets sovereign debt, lost a whopping 8.9%; meanwhile, the JPMorgan EMBI Global Diversified Index, which tracks U.S.-dollar-denominated emerging-markets sovereign and quasi-sovereign debt, lost a more modest 1.8%. Rising U.S. rates and inflation concerns as well as slowing Chinese growth and issues in the Chinese property sector contributed to the sell-off in emerging-markets debt. However, the strength of the U.S. dollar relative to many emerging-markets currencies explains why local currency did so much worse.

Despite the recent turmoil in emerging-markets local bonds, they could be an attractive option based on valuations. At the end of 2021, the emerging-markets local-currency bond Morningstar Category had a median SEC yield of 5.0%, which topped the median high-yield bond fund's SEC yield of 4.0%. In addition to the attractive yield, many emerging-markets central banks have proactively raised real rates (interest rates adjusted for inflation) at a much faster pace to their developed-markets peers, as many emerging-markets central banks have been less willing to test if current inflation will prove transitory. As a result, the difference between emerging-markets real rates and developed-markets real rates is at a 15-year high. This combined with supportive oil dynamics, continued growth recovery, and peaking inflation could lead to a rebound in emerging-markets local debt.

Still, emerging-markets bonds carry amplified risks alongside their lofty yields and can move more in line with equities than developed-markets debt. Political, macroeconomic, and regulatory developments can all impact credit risk and introduce volatility. Sovereign issuers are a mix of investment-grade and junk-rated. Local-currency-denominated emerging-markets debt is particularly volatile given its potent currency risk. Given the elevated risks, emerging-markets local bonds are best suited for a supporting role in a portfolio.

For investors seeking a pure-play emerging-markets local-debt strategy, Pimco Emerging Markets Local Currency and Bond (PELBX) offers exposure to local rates and currencies. However, we give the fund a Morningstar Analyst Rating of Neutral because its emerging-markets debt team has struggled to distinguish itself.

Another way to gain exposure is through a wide-ranging fund with a meaningful allocation to the sector. Gold-rated Western Asset Core Plus Bond (WACPX), which resides in the intermediate core-plus bond category, sports a well-diversified portfolio focused on the investment-grade space but typically carries more emerging-markets local debt than peers. In recent years, the team has not hedged its local-currency exposure back to the U.S. dollar, which can create more volatility. Fortunately, the strategy has a deep and experienced team to lean on. While its emerging-markets local-debt bet has faced some challenges in recent years, the team's investment theses have a solid track record of panning out: The institutional shares' 10-year 4.5% annualized return through December 2021 blew past its typical category peer.

Dodge & Cox Global Bond (DODLX), which has an Analyst Rating of Gold, is a world-bond fund with a tilt toward corporate bonds. The experienced managers here build a concentrated, high-conviction portfolio with a notably high corporate credit stake, which typically represents half of the portfolio. The bulk of its emerging-markets allocation (29% of assets in December 2021) is in local-currency sovereign debt (20%). The managers tend to keep foreign-currency exposure to around 20% on average. Its helping of emerging-markets local debt has helped it serve investors well over time. From its May 2014 inception through December 2021, it outpaced all peers.

Mike Mulach does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.