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EM’s Uninvited Guest: US Duration
Investors often allocate to emerging markets debt to capture compelling stories of growth, reform and opportunity in developing economies. Yet, all too often, these carefully chosen EM exposures are overshadowed by movements in US Treasury yields. It’s a frustrating reality that can significantly amplify volatility in the asset class’s returns, and recent weeks have offered a reminder of just how powerful this effect can be.
Breaking Down EM Return Components:
Dollar-denominated bond returns can be broken down into two components: spread and US interest rate returns. The spread component is tied directly to the fundamentals of the issuing country, reflecting factors such as creditworthiness and economic strength. In contrast, the interest rate component is linked to movements in US treasury yields.
For instance, when you buy a dollar-denominated bond from countries like Poland or Mexico, you’re not just expressing a view on their economic future—you’re also taking on exposure to US interest rate risk. A 7-year dollar-denominated bond issued by Poland, for example, typically has a duration of about 6 to 7 years. This means that if US interest rates rise by 1%, the bond's price could decline by approximately 6% to 7%.
This embedded risk is a double-edged sword. In years like 2020, falling US interest rates provided a helpful tailwind, boosting returns. Conversely, in years like 2022, sharply rising rates became a powerful headwind, wiping out gains and intensifying losses. In any case, adding US interest rate risk into an EM debt portfolio introduces unwanted volatility driven by factors completely exogenous to the developing economy that an investor is seeking to gain exposure to.
The Proof is in the Pudding: A Recent Example
Between the end of Q3 2024 and the first few weeks of Q4, dollar-denominated EM debt returns, as measured by the J.P. Morgan EMBI Global Diversified Index, underwent a sharp reversal returning +6.15% in Q3 and -1.72% for the month of October. However, a closer analysis reveals that this shift was driven entirely by the US treasury return component, while the performance of components linked to EM assets — the spread return— remained stable, or even improved, between periods. In Q3, the spread component contributed +0.95% to the index’s total return and in October it contributed +1.10%.
The Active Advantage
While the influence of the index’s components has fluctuated over time, movements in US treasuries have grown increasingly dominant in shaping total returns over the past year. As shown in the chart below, the US treasury component’s correlation to return has increased to over 0.8, while the impact of the spread component has declined. This decoupling reached its lowest point in more than a decade in October, with the spread component — or the component of the index affected by EM credit fundaments — showing a correlation of less than 0.2 to total returns. While multiple factors may be driving this shift, the result is an EM index that behaves more like a US treasury index.
For investors focused on capturing idiosyncratic EM stories—such as sovereign credit upgrades, fiscal reforms, or economic turnarounds—this US interest rate whiplash feels misplaced. Yet understanding this aspect of dollar-denominated EM returns is crucial. An active approach to investing in the asset class allows investors to better navigate the embedded US interest rate risks and potentially reduce unnecessary volatility, helping to make sure no unwanted guests crash the party.
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