Why advisors should consider emerging markets bonds in 2024

Key highlights

The big picture: Vanguard’s active fixed income team believes EM bonds could outperform much of the rest of the fixed income market in 2024 because of the likelihood of declining global interest rates, the current yield premium over U.S. investment-grade bonds, and a longer duration profile than U.S. high-yield.

Why it matters:  Advisors typically need to proactively allocate to EM bonds, since they are often a small part of core or core-plus strategies and typically not included in model portfolios.

Strong returns in 2023: EM bonds, as measured by the JPMorgan EMBI Global Diversified Index, returned 11.1% last year. A key driver of strong EM credit returns in 2023 was a supportive demand and supply dynamic. Investment grade (IG) issuers outperformed their fiscal budgets in 2023, limiting their need to issue debt. High-yield (HY) issuers faced prohibitively high funding costs comprised of high treasury yields plus wide spreads and turned instead to official creditors for funding.

As EM IG spreads tightened due to the lack of supply throughout 2023, we used the opportunity to rotate out of EM IG into high-yield EM issuers where our team identified compelling valuations coupled with improving fundamentals. Additionally, we sought exposure in EM local currency bonds, capitalizing on falling inflation and high real yields in EM economies. In our multi-sector funds, we substituted out EM IG for U.S. credit where valuations were more attractive.

Expecting another strong year in 2024: Coming into this year, we were defensively positioned in EM IG, expecting more normal totals of debt supply to push spreads wider. Following large front-loaded new issue supply, EM IG spreads are now at attractive levels versus U.S. credit and set up EM debt for outperformance. Our 2024 macroeconomic base case features slowing inflation and growth cushioned by FED rate cuts. This environment is supportive of fixed income assets in general and credit assets in particular.

In addition to attractive valuations, the EM asset class benefits from a unique combination of wide spreads and long duration, something that neither U.S. IG nor U.S. HY can offer. This leaves EM debt uniquely poised to benefit from a rally in rates as central banks cut and supportive risk appetite as growth normalizes. With strong investor demand for fixed income assets and historically expensive valuations in U.S. corporate bonds, EM debt is likely to benefit from increased investor demand. This demand is likely to overwhelm supply in the coming month, helping drive outperformance in EM debt.

How to access:

Three Vanguard products offer significant exposure to emerging markets bonds:

Active

Vanguard Emerging Markets Bond Fund (VEGBX)

Vanguard Multi-Sector Income Bond Fund (VMSAX)

Index

Emerging Markets Government Bond ETF (VWOB)

For more information about Vanguard funds or Vanguard ETFs, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.

Bonds of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

High-yield bonds generally have medium- and lower-range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings.