Why Emerging-Market Investors Are Favoring Local-Currency Bonds Over Dollar Debt

Local-currency emerging-market sovereign debt is attracting investors because it offers a different return opportunity from dollar-denominated EM bonds. As U.S. Treasury yields rose—with the 10-year Treasury quoted at 5.00% on September 19—hard-currency EM bonds faced tougher competition from comparatively low-risk U.S. government debt. 17

The shift is not a broad claim that emerging markets are immune to tighter global financial conditions. It is a relative-value call: investors see more attractive valuations in selected local markets and an opportunity to earn carry, but they are accepting direct exposure to local currencies in return. 1823

Why higher Treasury yields pressure dollar EM bonds

Dollar-denominated EM sovereign bonds are often assessed against U.S. Treasuries plus a credit spread. When Treasury yields rise, the yield investors can earn from U.S. government bonds rises too. That raises the compensation investors may demand for taking EM sovereign, liquidity and political risk, putting pressure on dollar-bond prices unless spreads tighten enough to offset the move.

That backdrop has dimmed the appeal of external, or hard-currency, debt relative to domestic-currency bonds, according to the September market reporting on the rotation. 18

What investors get from local-currency debt

A local-currency bond’s dollar return has three main moving parts:

• Income, or carry: the coupon and yield earned in the local market.
• Local rates: falling local yields generally lift bond prices, while rising yields hurt them.
• Foreign exchange: appreciation or depreciation of the bond’s currency against the dollar changes the return for a dollar-based investor.

The carry element matters because investors can seek to borrow in lower-yielding currencies and invest in higher-yielding assets. That opportunity, alongside attractive valuations, has been cited as a central reason for the preference for local EM debt. 1821

Generali’s August outlook similarly favored local over external EM debt on valuation grounds, while noting that local rates offered more value. 23

The performance and positioning behind the rotation

The preference has shown up in relative returns. A Bloomberg gauge of domestic EM debt beat an index of dollar-denominated EM bonds by more than three percentage points from the end of June to the September report. 18

Positioning strengthened as well. In Bank of America’s September 4–9 survey of 38 global fixed-income managers overseeing a combined $444 billion, 84% said they were overweight local EM debt relative to hard-currency bonds. That was up from 38% in August. 4

Strong positioning can validate a prevailing investment view, but it also leaves the trade more exposed if the assumptions behind it change. A rapid dollar rally or a broad risk-off episode can force investors to reassess both currency exposure and local-rate risk at the same time.

The central vulnerability: currency losses

The key difference between local and dollar EM debt is foreign exchange exposure. A local bond can deliver its coupon and rally in its domestic market, yet still produce a loss for a dollar-based investor if the local currency depreciates sharply.

Market commentary has explicitly identified the dollar outlook, valuations and expectations for EM central-bank policy as the three main drivers of local-currency EM bond performance. It also warned that heightened global currency uncertainty had pushed local-currency bond spreads higher. 22

That makes a stronger dollar especially dangerous. It can reduce or eliminate carry gains through FX depreciation and may discourage allocations to local-currency EM debt. 21

Other ways the trade could break down

Several risks could challenge the local-debt advantage:

Elevated global and local yields

If U.S. yields remain high, global financing conditions can stay restrictive. If local yields rise as well, bond prices fall. Investors then face a potential double hit from weaker bond valuations and weaker currencies.

Less room for domestic rate cuts

Part of the appeal of local bonds can be the prospect that EM central banks lower rates, helping existing bond prices. But inflation, fiscal stress or currency weakness may limit that room. BNP Paribas identifies the potential for EM central-bank cuts as one of the major performance drivers—not a certainty. 22

Geopolitical and risk-off shocks

Geopolitical uncertainty can shift investors toward dollar assets and away from riskier markets. Generali noted that EM sovereign bonds had been resilient to geopolitical tensions, but resilience does not remove the risk of abrupt changes in investor appetite. 23

Bottom line

Investors are favoring local-currency EM debt because rising Treasury yields have made dollar EM bonds harder to justify on a relative basis, while local markets offer carry and, in some cases, more appealing valuations. That combination helped local debt outperform hard-currency peers and drew a pronounced institutional overweight. 184

But the return is conditional. Local EM bonds add FX risk to duration and sovereign risk, so a stronger dollar, sticky yields or a geopolitical shock can quickly outweigh the carry that made the trade attractive in the first place. 2122