Currently, investors buying into the Emerging markets are looking to build a buffer against rising rates in the US. However, it is necessary to have a clear investment horizon because if it necessary to sell these securities before maturity, the loss could be considerable.
In the mid-term, local currency EM bonds might be a better investment as their performance is tightly correlated to their FX component. The ideal environment for EM currencies to strengthen would be when the US economy is expanding. The reflation trade sees the economy growing faster than expected, sending commodity prices higher together with inflation, making it a perfect storm for bond values. However, in this environment interest rate differentials move in favour of emerging markets as local currency advances.
Another factor to keep in mind is that the value of hard currency emerging market bonds is more volatile than local currency peers. Below you will find Bloomberg Barclays emerging sovereign market index for local and hard currency debt. As you can see, in times of high volatility USD EM bonds is more volatile. This is mainly due to the fact that local currency debt doesn’t need to adjust much in light of the exposure it has to local FX rates. This is a buffer that USD EM debt lacks, making it more volatile.
As a conclusion, investors should reconsider holding emerging market bonds starting from US dollar EM notes. Even though USD emerging market debt can provide a much-needed buffer against rising inflation, it poses a serious capital loss threat in light of current historic low yields and rising US real rates. A that point, the only way to avoid big losses would be the one of holding the bonds until maturity.