EM investors pile into local bonds as Fed hike dims dollar debt

Emerging-market investors are leaning into local-currency sovereign debt as a sharp rise in U.S. Treasury yields erodes the appeal of dollar-denominated bonds issued by developing nations, according to Bloomberg.bloomberg

The shift comes in the wake of the Federal Reserve's September 16 decision to raise its benchmark interest rate by 25 basis points to a range of 3.75% to 4%, the first hike since 2023. The move, approved unanimously under Chair Kevin Warsh, sent the 10-year Treasury yield back above 5% and rattled global bond markets. For holders of dollar-denominated emerging-market debt, rising U.S. yields translate directly into falling prices and tighter financial conditions — making local-currency alternatives more attractive by comparison.cnbc+2

Carry Trades and Valuations Drive the Pivot

Behind the rotation are attractive valuations in local bonds and opportunities in carry trades, where investors borrow in low-yielding currencies to invest in higher-yielding assets. A Bloomberg gauge of domestic emerging-market debt has beaten an index of dollar-denominated bonds by more than 3 percentage points since the end of June, on pace for the largest quarterly outperformance since 2022.economictimes.indiatimes+1

A Bank of America ↘ 0.68% survey of 38 global fixed-income fund managers overseeing $444 billion in combined assets found that 84% of respondents were overweight local emerging-market debt relative to hard-currency bonds, up from just 38% in August. The poll was conducted between September 4 and 9.economictimes.indiatimes

The enthusiasm for carry has been building for months. Cathy Hepworth, who heads PGIM's emerging-markets debt team, summarized the theme earlier this year: "Carry, carry, carry".The Edge Malaysia

Risks Remain After the Fed's Hawkish Turn

The trade faces a clear test. The Fed's new projections show the policy rate rising to a 4.00%–4.25% range by year-end, with another hike expected before December. A renewed advance in the dollar could turn investors away from local-currency debt, which is vulnerable to exchange-rate swings.reuters+1

State Street Global Advisors ↗ 0.20% noted in August that local-currency bonds had proved resilient even as hard-currency debt lagged, but cautioned that firmer rates and geopolitical uncertainty remained headwinds. For now, the gap between local and dollar-denominated returns suggests fund managers are betting the carry opportunity outweighs the risks from a more hawkish Fed.ssga