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Emerging-Markets Bonds in a Rising U.S. Dollar Environment

Look to funds that focus on U.S. dollar-denominated debt.

Patricia Oey 01 December, 2014 | 15:51

The U.S. dollar has been rising and likely will remain strong in the medium term, thanks to a relatively healthier U.S. economy and the expectation that the U.S. will normalize its monetary policy before the eurozone and Japan. In a strong U.S. dollar environment, investors considering emerging-markets bonds to diversify their portfolios may want to focus on funds that invest in U.S. dollar-denominated sovereign debt. While a strong U.S. dollar makes it more expensive for emerging-markets sovereigns to repay their dollar-denominated debt, we note that for the most part, emerging-markets countries have ample foreign reserves. In addition, most emerging-markets countries' U.S. dollar debt is nowhere near levels seen in the mid-1990s--at that time, high levels of U.S. dollar-denominated debt helped contribute to the Asian financial crisis.

Suitability
U.S. dollar-denominated emerging-markets bonds have historically exhibited low correlations to U.S. bonds. This is due to the fact that emerging-markets sovereign bonds carry credit risk, whereas U.S. Treasuries are "risk-free." During the past five years, the correlation between the emerging-markets bond benchmark, the J.P. Morgan Emerging Market Bond Index (J.P. Morgan EMBI), and the Barclays U.S. Aggregate Bond Index has been 0.47.

Both the PowerShares and iShares emerging-markets bond exchange-traded funds hold only U.S.-dollar-denominated bonds. As such, they do not have any direct foreign-currency exposure. Some investors may prefer to invest in local-currency bonds, which can provide better diversification through exposure to local rate trends and foreign currency. This foreign-currency exposure can provide a boost if emerging-markets currencies appreciate against the U.S. dollar, but can be a downer if they slide versus the greenback. Local-currency debt also tends to carry higher credit ratings, relative to hard-currency debt. This is because it can be difficult for countries with weak fundamentals to issue local-currency bonds and as a result tend to issue hard-currency debt. 

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About Author

Patricia Oey  Patricia Oey is an ETF analyst at Morningstar.

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