The Asset Class Hiding in Plain Sight

By: Lewis Jones, William Blair Investment Management

Investors may not need a weaker dollar — just a less challenging currency backdrop — to unlock the appeal of EM local currency debt.

For years, Emerging Markets (EM) local currency debt has been one of the most misunderstood segments of the fixed-income market. It can offer attractive yields, exposure to economies growing faster than many developed markets, and diversification benefits that can complement traditional fixed-income allocations. Despite these advantages, many investors have remained cautious, because they often don’t appreciate the full picture: EM local debt is often evaluated as a currency story when it should be evaluated as both a bond and currency story.

Local Fundamentals Have Improved

The bond story is straightforward: One of the most underappreciated developments in EMs over the past two decades has been the evolution of monetary policy.

Historically, many investors viewed EMs as countries with weak institutions, unstable inflation dynamics, and limited policy credibility. While those perceptions may have been justified decades ago, the reality today is often markedly different.

Many EM central banks have established strong inflation-fighting credentials and have demonstrated a willingness to act proactively when inflation pressures emerge. In several cases, policymakers began tightening monetary policy well before developed market (DM) central banks responded to post-pandemic inflation.

The result is that many EMs continue to offer substantially higher real interest rates than those available in DMs. For fixed-income investors, those higher real rates provide an important source of return and can help create a larger cushion against future volatility.

At the same time, many EMs continue to benefit from stronger long-term growth prospects than their DM counterparts. While individual countries face unique challenges, the broader EM universe remains supported by favorable demographics, rising consumption, infrastructure investment, and increasing participation in global trade.

These improving local debt fundamentals have benefited underlying bonds.

Looking Beyond the Headlines

If local debt fundamentals have improved, why has the asset class not consistently translated those advantages into stronger investor returns?

The answer lies in the fact that EM local currency debt has two distinct return drivers: the performance of the underlying bonds and the movement of local currencies relative to the investor’s home currency.

This distinction is important because the currency component — particularly during periods of U.S. dollar strength — has often masked much of the asset class’s underlying value.

When EM currencies weaken against the U.S. dollar, the currency impact can overwhelm otherwise attractive bond returns, creating the impression that the asset class itself is underperforming.

The challenge has been the extraordinary strength of the U.S. dollar over much of the past decade. Sustained dollar appreciation has historically created headwinds for EM currencies, frequently offsetting a meaningful portion of local bond returns for U.S.-based investors.

Many EM currencies now appear inexpensive relative to their historical valuations. In many cases, they remain competitive from a trade perspective and are supported by improving economic fundamentals. Yet valuation alone is often insufficient to drive appreciation while the dollar remains in a prolonged uptrend.

We believe the key question for investors is whether that backdrop is beginning to change. If the period of exceptional dollar strength that characterized much of the past decade is fading, investors may be able to capture not only the attractive yields available in local bond markets, but also potential support from currencies that appear historically undervalued.

Why This Cycle May Be Different

Looking forward, investors may be approaching a different environment. After more than a decade of exceptional U.S. dollar strength, the forces that supported the dollar’s outperformance may be moderating. While forecasting currencies is notoriously difficult, investors may not need a sharply weaker dollar for EM local debt to benefit.

Rather than requiring a prolonged period of dollar weakness, local debt may simply benefit from a more stable dollar backdrop. If the currency headwind becomes less severe, investors could gain greater exposure to the underlying drivers that have long supported the asset class: elevated yields, attractive carry, and favorable real interest rate differentials.

Importantly, EM currencies do not need to appreciate dramatically for local debt to become more attractive. A reduction in currency volatility or a moderation in dollar strength may be sufficient to allow the bond component of returns to play a larger role in overall performance. This possibility becomes increasingly relevant in a world where developed-market bond yields remain relatively constrained and investors continue to search for differentiated sources of income and diversification.

The Opportunity in Plain Sight

EM local debt is unlikely to become a risk-free asset class. Currency volatility, political developments, commodity price shocks, and global economic uncertainty may continue to influence returns.

Yet as we have shown, investors may be overlooking how much the asset class has evolved. While much of the attention has focused on currency movements, the underlying fundamentals tell a different story — one characterized by improved policy credibility, real yields, and stronger economic prospects across many EMs.

For much of the past decade, a powerful U.S. dollar obscured those strengths. If that headwind becomes less severe, investors may find that the return potential of EM local debt looks different than it has in recent memory. Sometimes the most compelling opportunities are not new opportunities at all — they are familiar asset classes viewed through a new lens.

Lewis Jones, CFA, FRM, is a local currency portfolio manager on William Blair’s emerging markets debt (EMD) team. He also researches Latin American local currency markets. Before joining William Blair, Lewis was the lead portfolio manager for EMD local currency strategies at NN Investment Partners; he also covered Latin America. Before joining NNIP in 2016, Lewis was an EMD portfolio manager at BNP Paribas Investment Partners and Fischer Francis Trees & Watts. Before that, Lewis held emerging markets fixed-income research and portfolio management roles at Rexiter Capital Management. Lewis received a B.Com. from the University of Alberta.