Fidelity experts see positive—but less robust—growth in the months ahead. Emerging-market debt solidly outperformed its developed-market peers in the second quarter of 2014.

What could this mean for investors? Get insights from one of Fidelity’s emerging-market debt investment professionals, Jonathan Kelly, portfolio manager.

The transformation of emerging-market debt

In 2013, investors left emerging market debt (EMD) in droves, leading to a 6.6% decline for the asset class—its first negative calendar year return since 2008. So far, though, 2014 has been a very different story, particularly for U.S. dollar-denominated EM debt. The JPMorgan Emerging Markets Bond Index Global gained 5.4% in the second quarter— the highest of any debt category—and is up 9.1% through the first seven months of the year, as investors return to the fold.

So what’s behind this seemingly abrupt transformation of the EM debt market? Several interrelated factors are at play.

The first is the surprising decrease in U.S. interest rates so far this year, due to disappointing growth in the domestic economy. First-quarter gross domestic product (GDP) dropped at an annual rate of -2.1%, largely the reflection of a weather-related slump. Real gross domestic product (GDP) increased 4.0 percent at an annual rate in the second quarter of 2014, according to the advance estimate from the Bureau of Economic Analysis.

All else being equal, long-duration asset classes tend to benefit when interest rates are falling, and U.S.-dollar denominated emerging-market debt is in the long-duration category. So, simply put, EMD has outperformed this year, at least in part, for the exact opposite reason it underperformed last year.

Credit market conditions are another important component of EMD performance. When investors are more willing to assume risk, it provides a more conducive backdrop for EMD. To measure investors’ comfort level with risk, one can point to the Chicago Board Options Exchange Market Volatility Index (VIX), which has touched multi-year lows in 2014, implying that market participants expect fewer surprises particularly compared to last year.

A cautious look ahead

EMD has offered a significant yield advantage in 2014 compared to other foreign and U.S. fixed- income sectors (see chart). After reaching a high of nearly 6.5% in February, some of that yield advantage eroded, not surprising considering EMD’s year-to-date return of 9.1% (as of July 28), as measured by the JPMorgan Emerging Markets Bond Index Global. Still, its current yield of 5.3% remains attractive, especially compared with the 10-year U.S. Treasury, which yields 2.5%. And given the relative underperformance of local-currency EM debt year to date, this market could offer some compelling opportunities.

However, we are somewhat cautious about the remainder of 2014. The EMD market had attractive valuations coming into this year, but it now appears to be more fully valued. That’s not to suggest our outlook is for doom and gloom, just that more caution is warranted given the strong market performance we’ve seen through July.

From a macroeconomic perspective, separation remains among EMD countries, even among nations within the same region. In Latin America, for example, Brazil appears stuck in a stagflationary environment, while Colombia continues to experience relatively strong growth. In China, there is some evidence that government stimulus is having a small positive impact in the near term, but questions still overhang the property sector and portions of the industrial sector there. Elsewhere, growth remains relatively strong in several Sub-Saharan African countries, while the European Central Bank’s stimulus efforts have helped reduce volatility in most European bond markets. Overall, though, inconsistency in the growth picture should be supportive of bond markets.

On the other hand, geopolitical issues have had some meaningfully negative effects on certain countries. In light of the ongoing Russia-Ukraine conflict, bonds of both nations have been understandably volatile, and economic activity in both countries continues to suffer. There is a significant interdependence between Russia and Western Europe, so this remains an area of concern. So far, though, the overall impact has been relatively contained. In the Middle East, civil disruptions in Iraq and violence in the Gaza Strip likewise have loomed large in the headlines, but not necessarily in investors’ minds. This is testament to the extremely strong market backdrop, but another reason for additional caution looking forward.

We currently reside in an environment where U.S. Treasury movements should continue to have a direct influence on emerging-market debt performance. In fact, if stronger U.S. economic growth leads to higher domestic interest rates, it could push EMD local market interest rates higher still. Conversely, lower interest rates in the U.S. could lead to stable or lower local market interest rates. Either way, we see the current link between EMD and the direction of U.S. economic potential and monetary policy to be especially strong.

To be sure, the macroeconomic backdrop in emerging markets remains uncertain. Yet there have been signs of improvement and optimism. This, combined with the benign backdrop mentioned earlier, has provided support for EMD for the majority of 2014. Significant wild cards, however, are the hostilities between Russia and Ukraine, and the unfolding developments in several Middle East hot spots.

• Jonathan Kelly manages Fidelity Series Emerging Markets Debt Fund and co-manages Fidelity Strategic Income Fund.
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Past performance is no guarantee of future results.

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Foreign markets can be more volatile than U.S. markets due to increased risks of adverse issuer, political, market, or economic developments, all of which are magnified in emerging markets. These risks are particularly significant for investments that focus on a single country or region.

In general the bond market is volatile, and fixed-income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed-income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible. High-yield/noninvestment-grade bonds involve greater price volatility and risk of default than investment-grade bonds.

Index definitions

JPM EMBI Global Index, and its country sub-indices, tracks total returns for traded external debt instruments issued by emerging-market sovereign and quasi-sovereign entities.

Barclays U.S. Aggregate Bond Index is an unmanaged, market valueweighted performance benchmark for investment-grade fixed-rate debt issues, including government, corporate, assetbacked, and mortgagebacked securities with maturities of at least one year.

Citigroup Non-USD Group-of-Seven (G7) Index is designed to measure the unhedged performance of the government bond markets of the G7 excluding the U.S. which are Japan, Germany, France, United Kingdom, Italy, and Canada. Issues included in the index have fixed-rate coupons and maturities of one year or more.

MSCI Emerging Markets (EM) Index is an unmanaged market capitalization-weighted index of over 850 stocks traded in 21 world markets.

Standard & Poor’s 500 Index (S&P 500) is an unmanaged market capitalization-weighted index of 500 widely held U.S. stocks and includes reinvestment of dividends.

MSCI Europe, Australasia, Far East (EAFE) Index is an unmanaged market capitalization-weighted index designed to represent the performance of developed stock markets outside the U.S. and Canada.

Barclays ABS Index is a market value-weighted index that covers fixedrate asset-backed securities with average lives greater than or equal to one year and that are part of a public deal; the index covers the following collateral types: credit cards, autos, home equity loans, stranded-cost utility (ratereduction bonds), and manufactured housing.

Barclays U.S. Agency Bond Index is a market value-weighted index of U.S. agency government and investment-grade corporate fixed-rate debt issues.

Barclays CMBS Index is designed to mirror commercial mortgage-backed securities of investmentgrade quality (Baa3/BBB-/BBB- or above) using Moody’s, S&P, and Fitch, respectively, with maturities of at least one year. Barclays U.S. Credit Bond Index is a market value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more. BofA Merrill Lynch U.S. High Yield Master II Index tracks the performance of below-investment-grade, but not in default, U.S. dollar-denominated corporate bonds publicly issued in the U.S. market, and includes issues with a credit rating of BBB or below, as rated by Moody’s and S&P. Standard & Poor’s/Loan Syndications and Trading Association (S&P/ LSTA) Leveraged Performing Loan Index is a market value-weighted index designed to represent the performance of U.S. dollar-denominated, institutional leveraged performing loan portfolios (excluding loans in payment default) using current market weightings, spreads, and interest payments.

Barclays Long U.S. Government Credit Index includes all publicly issued U.S. government and corporate securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value.

Barclays U.S. MBS Index is a market value-weighted index of fixed-rate securities that represent interests in pools of mortgage loans, including balloon mortgages, with original terms of 15 and 30 years that are issued by the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corp. (FHLMC).

Barclays Global Treasury Index tracks fixedrate local currency government debt of investment-grade countries in developed and EM markets.

Barclays Municipal Bond Index is a market value-weighted index of investment-grade municipal bonds with maturities of one year or more. Barclays U.S. Treasury Inflation-Protected Securities (TIPS) Index (Series-L) is a market value-weighted index that measures the performance of inflationprotected securities issued by the U.S. Treasury.

Barclays U.S. Treasury Bond Index is a market value-weighted index of public obligations of the U.S. Treasury with maturities of one year or more.

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