EMERGING MARKET bonds have posted impressive returns over the past few decades, as developing economies have grown more robust. That, in turn, has bolstered the credit quality of emerging market debt, resulting in a narrowing of the spread between the yield on emerging market debt and that available on U.S. Treasury bonds.
From here, however, returns are likely to be more muted. As of year-end 2020, emerging market debt was offering relatively low yields. Moreover, the historical tightening of the spread between emerging market debt and Treasury bonds was a onetime gain. The spread may tighten further, but the big gains have already been had. Also keep in mind that, in a crisis, emerging market debt funds can suffer steep losses, such as 2008’s 18% drubbing.
Two decades ago, emerging market debt was often denominated in U.S. dollars, so investors didn’t have to worry about currency risk. Today, emerging market governments—which are easily the biggest issuers of emerging market debt—are more likely to sell bonds denominated in their own currencies. These local currency bonds will be more volatile, but could prove to be a better diversifier for a portfolio that’s mostly devoted to U.S. stocks and bonds.
Intrigued? Check out funds such as Fidelity New Markets Income Fund, Vanguard Emerging Markets Bond Fund and Vanguard Emerging Markets Government Bond Index Fund. Before buying an emerging market bond fund, find out whether the fund focuses on dollar-denominated bonds, local currency bonds or some combination of the two, so you know how much currency risk you’re taking.
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