Emerging Market Local Debt—What Will Drive Returns in 2013?

Chief Investment Officer, Fixed Income and Model Portfolios

02/13/2013

Investors were well compensated for investing in riskier fixed income sectors in 2012. With U.S. Treasuries and investment-grade securities offering reduced income potential, many investors rushed to higher-yielding sectors in what could be characterized as a relentless pursuit of income. Total returns for sectors such as U.S. High Yield and Emerging Market (EM) USD Sovereigns were bolstered by significant compression in the additional amount of yield that investors demand for assuming credit risk. EM local currency debt also enjoyed significant principal returns as local rates declined in step with aggressive central bank rate cuts.

We believe 2013 will be a different story. Selectivity and fundamentals are poised to play a more critical role in generating returns this year. In other words, the relentless pursuit of income may evolve into a more prudent pursuit of income. Investors and managers may more selectively target opportunities and anticipate lower absolute returns but continue to search for additional ways to generate income in their portfolios.

Looking ahead, investors should be asking what the primary driver of returns in fixed income will be in 2013. In emerging markets, we believe a majority of central banks have completed their cycle of interest rate cuts. This year, we believe that returns from EM local debt will largely be comprised of interest income and returns from currency appreciation against the U.S. dollar.

While we believe there will be a more balanced return (between income and currency appreciation) from EM local debt in 2013, we think a bias toward quality will offer differentiated performance to investors this year. Similar to our note about EM currency performance in 2012, EM Europe performed well after unnerved markets were calmed by the European Central Bank’s (ECB) debt purchasing scheme. Going forward, we believe EM Asia and EM Latin America should perform well when a focus on economic fundamentals returns to the market.

That said, last year the WisdomTree Emerging Markets Local Debt Fund (ELD) had its best calendar year performance since its inception in 2010. In fact, emerging market local debt as an asset class had better returns than even high-yield debt in 2012 thanks to aggressive interest rate cuts by many EM central banks.¹ While the future path of U.S. fixed income may be subject to debate, we believe investors should also be focusing on the potential drivers of return in international fixed income and emerging markets when making portfolio allocation decisions.

With less central bank activity, we believe interest rates in emerging market government debt will remain near current levels in 2013. As of January 31, 2013, ELD had a yield to maturity of 4.59% and duration of 4.84 years. By comparison, the current Five-Year U.S. Treasury Note has a comparable duration of 4.8 years.² While investors are exposed to foreign currency risk, we believe that these yield levels provide significant income potential from a portfolio that is currently comprised of 96% in investment-grade³ securities.

Another potential driver in 2013 could be returns from changes in currency. Since ELD’s inception,⁴ currency performance has actually had a negative impact on the Fund’s returns. However, we do not believe this will always be the case. Based on the Fund’s current exposures, the currencies in the Fund are down by 2.42% versus the U.S. dollar since inception.⁵ While we believe in the long-term prospects of EM currencies, appreciation will occur gradually. The rationale behind this belief is that as these countries continue to grow at faster rates than the U.S., there may be a bias for the currency to appreciate against the U.S. dollar. Eventually, as these countries transition from export-driven economies to more consumer-based ones, an appreciating currency will benefit as they import more products from abroad.

For investors seeking to increase their portfolio’s yield and gain exposure to a depreciating U.S. dollar, we believe emerging market local debt could continue to be an attractive asset class in 2013.

¹Bloomberg, December 31, 2012 ²Bloomberg, January 31, 2013. ³Credit ratings based on the highest rating of Standard & Poor’s, Moody’s and Fitch. ⁴August 9, 2010. ⁵WisdomTree, Bloomberg, 2012.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. In addition when interest rates fall, income may decline. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. Unlike typical exchange-traded funds, there is no index that the Fund attempts to track or replicate. Thus, the ability of the Fund to achieve its objective will depend on the effectiveness of the portfolio manager. Due to the investment strategy of this Fund, it may make higher capital gains distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.