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An Antidote for Rising Rates: EM Bonds

By Benjamin Shepherd on December 14, 2016

 

Almost a year to the day since the last interest rate increase, it seems  a near certainty that a hike will be announced today. Today’s move to take interest rates to a target range between 0.5% and 0.75% will still leave the rate well shy of its 5.2% historical average so, with inflation likely to pick up, odds are there are more hikes to come.

While we don’t know for sure what President-elect Trump will do – or what Congress will go along with – his much-hyped plan to boost infrastructure spending while cutting taxes is inflationary.

So what to buy when inflation and interest rates are creeping up, and you want yield?

One play to consider is emerging market (EM) bonds. I recommend iShares JPMorgan USD Emerging Market Bond Fund (NYSE: EMB), and get into the details in a minute.

Buying EM bonds is a bit counter intuitive since so many emerging market countries are major commodity producers. Rising rates typically makes the U.S. dollar stronger, which in turn pushes down other currencies. That drags down commodity prices and isn’t good for countries that are major commodity exporters.

But emerging market bonds were solid performers during the last two tightening cycles. Between June 1999 and July 2000, the Bloomberg Barclays Emerging Markets Aggregate Bond Index gained 22.9%, outperforming our own domestic bonds by a wide margin and even stocks. They didn’t do quite so well between June 2004 and July 2006, when the index returned 14.1% and EM stocks gained 33.5%, but those stocks where the only asset class that outperformed them.

In all fairness, EMs were hammered when the Fed was tightening between January 1994 and February 1995. EM stocks plunged 16.8% while EM bonds lost 19.1%, but that tightening cycle also helped set off the Mexican peso crisis which battered most every EM country.

The takeaway here is that when the global economy is generally healthy and the Fed is hiking rates basically just to keep inflation in check, that’s not an ill omen for EM bonds. So if you can get respectable capital appreciation and still better yields on EM bonds then our own, why wouldn’t you buy them?

Now buying bonds from even developed countries like Germany can be an expensive, time consuming hassle, so I’m not suggesting you try to piece together your own portfolio of EM bonds. Instead, there are many ETFs and mutual funds that will do that for you. They also generally come in two basic flavors: U.S. dollar denominated bonds and local currency.

I would stay away from local currency funds like Market Vectors Emerging Markets Local Currency ETF (NYSE: EMLC). While its gains have come in fits and starts, the dollar has been on a tear since May that has been a drag on the value of EM currencies. That’s been especially true since the election, which has seen the U.S. Dollar Index shoot up from a value of 96 to as high as 102. In fact, November’s jump was the biggest monthly move in nearly a year and it hasn’t come down much since.

Instead, I would go with iShares JPMorgan USD Emerging Market Bond Fund (NYSE: EMB). The bonds it holds are dollar denominated, so they’re fairly immune to swings in the dollar’s value. That said it still yields nearly 5% and makes monthly payouts, so it’s a great choice for income investors even as rising rates should produce some out sized returns from EM bonds.


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