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Emerging Market Bonds: “Dollar Denominated” Versus “Local Currency”

Investors have two options when it comes to investing in emerging market bonds. The first is to invest in the dollar-denominated debt issued by the world’s developing countries. Dollar denominated simply means that the bonds are issued in U.S. dollar terms, so U.S. investors do not need to convert to foreign currencies when they purchase the bonds. The result is that there is no impact from currency risk on top of the typical volatility associated with emerging market bonds.

The second type of emerging debt is bonds that are denominated in local currencies rather than U.S. dollars. In this case, the investor will have to convert their dollars to, for example, the Brazilian real prior to buying the bond. The result is that he or she will now see the value of the investment affected by currency fluctuations in addition to the price movement of the underlying bond.

Why is this? Think of it this way: an investor buys $1 million worth of Brazil’s local currency debt, but to do so they first need to convert their dollars into the local currency. A year later, the price of the bond is exactly the same, but the currency has appreciated 5% versus the dollar. When the investor sells the bond and converts back to U.S. dollars, that 5% appreciation leads to a 5% gain in the value of the investment – even though the price of the bond itself was unchanged.

Which is Better for You?

Investors who are looking to allocate a portion of their portfolio must make a choice between a dollar-denominated or local-currency bond fund. Some fund companies offer both: for example, the fixed-income behemoth PIMCO offers both the PIMCO Emerging Markets Bond Fund (ticker:PEBIX) as well as the PIMCO Local Emerging Bond Fund (PELBX). In the world of exchange-traded funds investors can choose between products such as the iShares JPMorgan USD Emerging Markets Bond Fund (EMB) or the Wisdom Tree Emerging Markets Local Debt Fund (ELD).

The benefit of local currency funds is two-fold. First, they allow investors to diversify their holdings away from the U.S. dollar. Second, it allows investors to benefit from the positive impact of emerging market nations’ stronger economic growth may have on their currencies over time.

At the same time, however, currency exposure adds another layer of volatility. This becomes particularly important during times when investors are looking to avoid risk. On these occasions, it’s reasonable to expect that local currency funds will underperform their dollar-denominated counterparts. Dollar-based debt may therefore be the better option for new investors in the asset class or those with a somewhat lower risk tolerance.

An example of how the performance of the two segments can differ: during September 2011, intensifying concerns about the European debt crisis sparked a flight to safety from higher-risk assets. In the midst of this selloff, EMB (the emerging markets ETF that holds dollar-denominated debt) returned -4.79%. In the same time period, ELD (which holds local currency debt) returned -10.24% – a huge difference in such a short period. Conversely, during the first two months of 2012 – an exceptionally positive period for the financial markets, ELD returned 7.53% and trounced EMB’s return of 4.51%. Over time, however, the difference tends to even out. Looking at the two PIMCO funds as an example, the five-year average annual return of the local currency fund and dollar-denominated funds were 7.37% and 8.04%, respectively, through June 6, 2013.

One final thought: many funds can move between both dollar- and local currency denominated bonds. Consequently, investigate potential investments thoroughly to make sure you have an accurate picture of just how risky a particular fund may be.