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By Bradley Krom

In part two of our discussion, we focus on the impact of recent changes in Federal Reserve (Fed) policy on locally-denominated fixed income across emerging markets (EM). As we noted in part one, higher short-term interest rates in emerging markets helped dampen losses from currency depreciation since the Fed began to "taper" its bond purchases in December. In this analysis, we take a broader view of the Fed's change in policy. In the charts below, we show the bond market's reaction to Ben Bernanke's taper comments from May 2013 and then look at the impact once the Fed actually started to reduce its bond purchases in December. Our primary takeaway from this analysis is that even though many emerging markets have rebounded, the rebound has not been particularly widespread. Yields remain considerably higher and currencies lower than May of last year. Compared to other fixed income sectors, we believe there is still opportunity for returns on account of high levels of income and further appreciation in EM currencies.

From the end of May 2013 through the end of the year, global fixed income markets came under pressure, and many EM currencies depreciated against the U.S. dollar. As we noted at the time, countries that were perceived by the market to be dependent on foreign funding came under the greatest amount of pressure. Indeed, many of these countries actually hiked interest rates in order to stem the depreciation pressures on their currencies. In January, the vast majority of emerging market fixed income and currencies began to bottom out. In our view, this marked a turning point as more investors began to reassess the underlying fundamentals against their valuations.

So far in 2014, bond yields around the world have declined. As we outline below, we believe that at current levels, EM local debt continues to appear attractively priced compared to other more traditional fixed income sectors and could prove to be much more resilient than the dramatic move we noted last summer.

(click to enlarge)

As shown in the chart above, many of the countries that were the most significant underperformers leading up to the implementation of tapering have been among the strongest outperformers so far this year. In most instances, higher income and the fall in yields from their peaks has helped many of these countries recoup losses experienced in 2013. As we noted in part one of this series, emerging market currencies have not necessarily fully participated in this recovery. In fact, only eight of 19 EM currencies in this analysis have appreciated against the U.S. dollar over this most recent period. Since tapering began in December 2013, currencies remain a modest detractor from overall returns of the asset class. In spite of this tepid rebound, total returns for investing in emerging market debt have been close to 4% over the period compared to 0.59% investing in five year U.S. Treasury bonds. In our view, this represents the fundamental value of emerging market debt. As long as currencies don't depreciate by significant margins at the same time, emerging market fixed income can help provide investors with much greater total returns than plain-vanilla U.S. fixed income. With currency volatility continuing to be constrained so far this year, we believe that emerging market fundamentals will continue to favor currency appreciation in the long run.

Emerging Market Fixed Income Returns: May 22, 2014 - July 31, 2014

Viewing the cumulative impact of tapering since May 22, 2013 in the table above, we continue to see a high degree of dispersion in the performance of emerging market countries. Again, currencies remain much weaker against the U.S. dollar with only three (Romania, South Korea and Poland) managing to appreciate over the period since Bernanke hinted at a reduction in bond purchases. However, an interesting element of this analysis shows that six out of 19 of these markets are no worse off than investing in U.S. 5-year Treasuries over this period. While volatility is undeniably higher for emerging market fixed income, yields of 1.75% in the United States provide limited options for attractive returns if rates rise by even a modest amount, in our view.

In sum, we continue to believe in the long-term story of investing in emerging market local debt. While currency performance has served as a headwind to total returns, we do not believe this will be the case in perpetuity. In our view, faster economic growth, improving fundamental balances and increases in investor sentiment should continue to provide a positive backdrop for emerging market fixed income in the long run.

Important Risks Related to this Article

Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments.

Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations.

Bradley Krom, Research Analyst

Bradley Krom joined WisdomTree as a member of the Fixed Income and Currency team in December 2010. He is involved in creating and communicating WisdomTree's thoughts on currency and fixed income markets, as well as analyzing existing and new fund strategies. Prior to joining WisdomTree, Bradley served as a senior trader on a proprietary trading desk at TransMarket Group.