By Fran Rodilosso, head of fixed income ETF portfolio management at VanEck.

Fran Rodilosso, head of fixed income ETF portfolio management at VanEck.

Looking for attractive yields? Look no further than emerging markets local currency bonds. These bonds provide significantly higher yields than those offered by developed markets bonds, both in nominal terms and in real terms, i.e., after adjusting for expected inflation. While higher yields often mean greater credit risk, local inflation levels can be a greater contributor to the nominal yields of emerging markets bonds.

Hawkish steps keep a lid on emerging markets inflation

The higher nominal yields of emerging markets local bonds compensate US dollar-based investors for the risk posed by local inflation, which can be associated with negative currency returns, particularly if inflation goes unchecked. But controlled inflation and positive real interest rates can generally be supportive for a local currency. In addition, positive real rates provide more room for emerging markets central banks to ease monetary policy if economic growth slows. This conventional policy tool may not be as effective in developed markets currently, given extremely low or even negative rates.

Real yields can also provide an indication of fundamental value versus looking only at nominal yields. As shown in the chart below, real yields among emerging markets economies (blue line) appear high relative to historical levels, and the differential between emerging markets and developed markets real yields (gray line) is attractive (the latest data show a 200 basis point yield advantage for emerging markets).

Emerging Markets Real Yields Are Attractive

Source: VanEck.

Inflation has generally remained under control in recent years in the countries represented in the JP Morgan GBI-EM Global Core Index. Even in countries where inflation has been more of a concern (e.g. Mexico and Argentina), central banks have taken hawkish steps, including raising interest rates, and inflation is expected to slow. As of 31 July 2017, the weighted average real 10-year government yield of countries in the index was 2.3%. In other words, investors were receiving 2.3% above expected inflation. To put that into context, the real yield on US government bonds was only 0.15%, and negative in other developed markets.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)