EM’s Uninvited Guest: US Duration

Investors are drawn to emerging markets (EM) debt for growth and reform opportunities, yet US Treasury yield fluctuations often overshadow these prospects, amplifying volatility. EM debt returns comprise two components: spread returns, tied to the issuing country's fundamentals, and interest rate returns, linked to US Treasury movements. This dual exposure can create volatility, as seen in 2020 when falling US rates boosted returns, versus 2022 when rising rates eroded gains.

Recent data from the J.P. Morgan EMBI Global Diversified Index illustrates this effect: a positive Q3 2024 return of 6.15% was followed by a -1.72% return in October, driven by US Treasury yield changes. The spread component's contribution remained stable, underscoring the outsized influence of US rates. The correlation between US Treasury movements and total returns has increased, while the impact of EM fundamentals has diminished, making the index behave more like a US Treasury index.

For investors seeking to capitalize on EM-specific stories like credit upgrades or economic reforms, this US rate-driven volatility is misaligned. An active management approach can help navigate these risks, reducing unwanted volatility and aligning returns more closely with EM fundamentals. Understanding these dynamics is vital for optimizing investment strategies in dollar-denominated EM debt.