Investors steer clear of emerging market bonds due to currency risk

People wait outside of a currency exchange house in Buenos Aires, Argentina, on Thursday, Aug. 30, 2018. 

Erica Canepa | Bloomberg | Getty Images

People wait outside of a currency exchange house in Buenos Aires, Argentina, on Thursday, Aug. 30, 2018. 

Mark McCarron, chief investment officer for Wescott Financial Advisory Group, believes in global diversification when it comes to investing in stocks. But not when it comes to bonds. The reason: currency risk.

“Our fixed income exposure is almost exclusively in U.S. dollars,” said McCarron, whose firm manages more than $2 billion in assets. “Currencies are volatile and they represent a much bigger part of bond returns than stock returns.

“Investors can get wiped out investing in global fixed income if they do it un-hedged,” he added.

This year may not yet be a full-fledged wipeout for emerging market currencies, but it’s getting close. The MSCI Emerging Markets Currency index, a basket of 26 EM currencies, was down 4.5 percent this year against the U.S. dollar through Oct. 24. That has contributed to double-digit losses in EM stocks and a 9.65 percent drop in EM local currency bonds.

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The U.S. dollar has also been rising against developed market currencies such as the euro and yen. “The strength of the U.S. dollar has surprised a lot of people,” said Peter Wilson, global fixed income strategist for Wells Fargo. “It’s been driven by a number of factors.”

Chief among them is the U.S. economy. While the year started with the narrative of global growth convergence, the paths of developed economies have diverged this year. With a boost from tax cuts and increased government spending, the U.S. economy is growing faster than it has for years. Meanwhile, the Eurozone has faltered and the Japanese economy has failed to respond to a very accommodating monetary policy. The result is a growing divergence of global economic growth and of central bank policies.

“The dollar has been getting stronger because interest rates are going up here versus the rest of the world,” said McCarron. The Federal Reserve hiked the Fed funds rate for the third time this year to the 2 percent to 2.25 percent range and is expected to hike once more in December. Rates in other developed markets remain at or near zero. “Even after adjusting for inflation, interest rates in the U.S. market are higher than in Europe, Japan and in many cases emerging markets,” he said.

With interest rate differentials between the U.S. and other developed markets widening over the last year, the demand for U.S. dollar assets has surged with the result of increased currency volatility. The DXY index of the U.S. dollar versus six developed market currencies is up 4.82 percent this year, now topping the rise of the dollar against emerging market currencies.

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