There has been an unexpected winner in the bond market in 2023: emerging market bonds. This is especially true for emerging market bonds priced in local currencies.

Currently, the gap in government borrowing costs between emerging markets and U.S. Treasuries is at its best level since 2000. The reason is that investors are pricing in imminent interest rate cuts in some big emerging economies, faster and deeper than in developed economies like the U.S. Here’s how you can profit.

Better Central Banking?

This actually makes sense. There has been a large narrowing of the credibility gap between central bankers in the developing world, who never swallowed the idea that inflation was “transitory,” and central bankers in the west who did.

For example, the Central Bank of Brazil raised rates a year before the Federal Reserve moved. Today, it seems inflation in the country has been tamed, and is now falling. Inflation in Brazil was 3.2% year-on-year in June, just below the central bank target of 3.25%. Interest rates remain at more than 13%, so there a lot of room for cuts, which are expected soon.

Even in Mexico, inflation is falling. It was down to 5% year-on-year in June versus policy rates of more than 11%. So again, there is a lot of room for the country to cut rates and for bonds to gain in price.

And we are seeing this pattern repeated elsewhere in the developing world, which is why investors in emerging market bonds are taking note that inflation may now fall faster than emerging market central banks cut rates, generating steeper real yields on local debt.

The reality is that central banks in Latin America and eastern Europe—regions that are home to the best performing bond markets in the world this year—acted more quickly to raise rates in response to the inflationary pressures that emerged when pandemic restrictions were eased and their economies reopened.

JPMorgan’s widely followed benchmark of emerging market local currency government bonds has delivered a 7.5% total return year-to-date, boosted by the Latin American sub-index—which has risen 21%—and by the central and eastern Europe sub-index, which has gained 11%. In contrast, U.S. government bonds have delivered a paltry total return of just 1.6% this year, as measured by an ICE Bank of America Index of government bonds.

The better central banking in these countries has also been boosting local currencies, adding to the gains on local currency bonds. Against a trade-weighted basket, the dollar is now down 12% since peaking last September. Currencies such as the Brazilian real, the Mexican and Colombian pesos, and the Polish zloty have all appreciated strongly against the dollar.

Also, as often happens, emerging market economies’ economic growth will outpace ours. Bank of America forecasts that emerging economies will grow by an average of 4.1% in 2024, ahead of a 0.5% growth in the U.S. That would be the highest growth differential in a decade.

More to Come

I believe there is more to come from these local currency emerging market bonds. This includes countries with still high real rates and/or sharply falling inflation abound, including the aforementioned Brazil and Mexico, as well as Peru, Indonesia, Poland, the Czech Republic, and South Africa.

It is difficult for retail investors in the U.S. to buy individual bonds from these markets, so the easiest path is to own them through an exchange traded fund (ETF). At the moment, I would focus on the outperforming segment—bonds denominated in local currencies. Fortunately, there are a number of these ETFs.

The two top performing ETFs in this category and their year-to-date returns are: WisdomTree Emerging Markets Local Debt Fund (ELD) at 13.28%, and First Trust Emerging Markets Local Currency Bond ETF (FEMB) at 15.38%. The current SEC 30-day yields are 6.57% and 6.4%, respectively. Both funds pay monthly dividends.

Here are top country positions in these funds.

FEMB:

• Indonesia—15.48%
• Brazil—13.34%
• South Africa—12.40%

ELD:

• Brazil—12.8%
• Indonesia—11.53%
• Colombia—9.50%

I like both of these funds, which are buys at their recent prices in the upper-$20s.

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