Emerging Market Bond Funds
Roughly $85 billion was invested in emerging markets bond funds and ETFs as of March 2013. There are two ways to play these types of bond funds: (1) invest in bonds denominated in the local currencies of the issuing country or (2) buy into a fund whose emerging bonds are denominated in a “hard currency,” such as dollars, euros, or yen.
Local currency bonds have the potential reward of appreciating if the currency appreciates against the dollar; hard currency bond investors avoid such currency risk. Local currency investors are betting on interest rates, emerging markets credit ratings, and currencies. Hard currency investors are betting on just interest rates and credit ratings.
Over the 10-year period of 2003–2012, currency appreciation represented ~ 17% of the total return from local currency emerging markets debt (source: T. Rowe Price). For the 2012 calendar year, a third of the money that went into emerging markets debt funds was backed by local currency. Over the past several years, PIMCO has been devoting more and more of its discretionary cash to emerging markets debt instruments. PIMCO has emerging markets debt funds in U.S. dollars (hard currency) and another in local currency.
Vanguard only offers emerging markets funds in hard currency. Vanguard believes investing in local currencies is a mistake: “Currencies have more downside risk than upside potential.” As of the end of 2012, there were close to 90 emerging markets bond funds—roughly 70% were dollar-denominated debt (source: Lipper).
While credit ratings in the U.S. have been falling, ratings for emerging countries have been rising. As some economies depreciate their currencies, emerging markets currencies will likely rise in value—helping out investors who own bonds (in local currencies) from these emerging economies.
A recent study by the Dutch investment management company Robeco shows emerging markets government bonds issued in U.S. dollars tend to fluctuate in value similar to U.S. high-yield corporate bonds. This may mean a portfolio may be better off replacing its high-yield position with emerging markets debt denominated in U.S. dollars. The market for emerging markets bonds is dominated by large global firms such as Vale (Brazilian mining) and Lukoil Holdings (Russian energy).
For advisors who want emerging markets bonds based on local currencies (and not on the U.S. dollar), there are a number of ETFs to choose from, including: iShares Emerging Markets Local Currency Bond Fund, Market Vectors Emerging Markets Local Currency Bond, SPDR Barclays Capital Emerging Markets Local Bond, and WisdomTree Emerg-ing Markets Local Debt.