For some, moments like these on Wall Street were made for the risk takers.
National economic advisor Larry Kudlow warned the Fed about an inverted yield curve and what it means for the economy: in short, it means recession. The Fed is hiking. The market is thinking the economy will slow, and that’s pushing Treasury yields lower. A higher front end, lower back end, is an inverted yield curve in the works. No one wants it.
If you’re of the mind that those days are coming, and many are, then one way to play it is by buying local currency bonds of investment grade emerging markets.
“The safest place to be right now is local currency bonds,” says Jan Dehn, head of research for the Ashmore Group in London. These are riskier than dollar-denominated debt, but for Dehn, this is his stock in trade.
On average, emerging market bond yields are around 6% and inflation is below 4%. Most of the companies and even some sovereign debt ratings are investment grade. Think China, for example. Investment grade bonds in those countries tend to be short-dated, with just 4.5 years of duration. And because everyone has been in U.S. bonds, the bond prices are not trading at high premiums (if at all).
Dollar bonds in emerging markets are likely to see short-term volatility due to the risk-off sentiment in the markets, but this will be a buying opportunity, says Dehn.
“This is all about the U.S. messing up, not emerging markets messing up,” he says, a nod to fiscal policy, trade tariffs, and the Fed putting nails and broken glass on the road to slow the economy.
Over the last week, since Fed chairman Jerome Powell confirmed three hikes this year and more next year, the 10-year Treasury bond that everyone was convinced was going to hit 3% and blow a hole in the Dow, is now trading at a discount, with yield of 2.81%,based on Friday’s close.
Dehn’s affection for risk is well known. Ashmore is an emerging market investment firm, so fixed income there is their bread and butter. But his call is more than a sales pitch, and the bullishness is more than anecdotal.
According to fund tracking firm EPFR Global, fund flows into U.S. government bond funds dropped by nearly half last week compared to the week before. Local currency emerging market bonds saw $743 million in inflows in the week ending March 21, compared to outflows of $356 million in hard currency emerging market bond funds (dollar, euro, yen). So far this year, investors have put $2 billion more to work in local currency emerging market bond funds than the $5.5 billion of inflows registered last year.
See: What Is The ‘Mueller Index’? — Forbes
Investors can buy local currency emerging market bond exchange traded funds. Some of the biggest ones include VanEck JP Morgan Local Currency Bond (EMLC), SPDR Barclays Emerging Market Local Currency (EBND) and the iShares Emerging Market Local (LEMB). Those are the three biggest by total assets. Each one is up on around 2% or more on the year while the dollar-denominated ones in this space are all down due to dollar weakness.
A weak dollar means stronger currencies elsewhere, like the Russian ruble and Brazilian real. Stronger currencies add to the total gains of a bond fund.
Fixed income investors who believe a weak dollar is here to stay for a while will often invest in foreign currency debt in an effort to eek out more capital gains off of the dollar.