Managing Interest Rate Risk in Emerging Markets

With persistent concerns about rising interest rates in the U.S., we believe an unsung benefit of allocations to emerging market (EM) fixed income is the ability to diversify away from developed market economies, interest rate cycles and currencies. However, as we have highlighted previously, not all emerging markets are created equal. Economists are predicting interest rate hikes by the end of 2013 for some EM countries and interest rate cuts for a few countries in the coming months.¹ WisdomTree offers a few different ways to manage your emerging market exposure. • Incorporating EM currencies with EM local debt positions enables investors to refine their exposure to EM interest rates while maintaining diversification away from the U.S. dollar • Central to this investment mix is the amount of income investors receive relative to the amount of interest rate risk they have in their portfolio For investors in EM fixed income, incorporating positions in EM currencies with EM local debt provides a means to tailor their interest rate exposure to their preferences while retaining exposure to non-U.S. currencies. It is important to remember that EM local rates are largely driven by local factors, resulting in an only modest correlation to overall changes in U.S. and global interest rates. Additionally, the local debt universe is still dominated by issues in the five-year sector, as opposed to more developed markets, which often feature longer durations and greater sensitivity to interest rate moves. Total returns in EM local debt can be thought of as driven by the three C’s: • Currency—changes in the value of the currency against the U.S. dollar • Carry—short-term interest rate differentials • Curve—potential additional income compensation for assuming interest rate risk EM forward currency contracts provide exposure to currency and short-term interest rate differentials without the incremental income and interest rate risk from bonds farther out on the yield curve. WisdomTree offers broad exposure to EM currencies and short-term interest rates through its WisdomTree Emerging Currency Fund (CEW) and exposure to EM local debt through its WisdomTree Emerging Markets Local Debt Fund (ELD). While the Funds feature different currency exposures, their regional exposures are fairly similar. Currently, the underlying securities in ELD have an embedded income yield of 4.66%, while CEW’s is approximately 3.66%.² In the graph below, we depict yield and duration statistics resulting from various combinations of CEW and ELD. As of March 31, 2013. Past performance is not indicative of future results. (For standardized performance, including the SEC 30-day yield for ELD, click here.) (For standardized performance, including the SEC 30-day yield for CEW, click here.) As this chart illustrates, by using the Funds in tandem, investors can target their interest rate risk in emerging markets. Currently, we prefer being overweight ELD vs. CEW, but should more central banks begin to bias toward interest rate increases, it may make sense to reduce interest rate risk. In both instances, we believe having exposure to locally denominated fixed income can provide an effective means of diversifying interest rate risk, potentially enhancing portfolio yield and diversifying into the currencies of countries that are currently driving global growth. From a total return perspective, ELD strongly outperformed CEW in 2012, as EM central banks cut rates and curves in many emerging markets flattened. As a result, the incremental income offered by ELD compared to CEW has narrowed.   ¹Bloomberg, 4/8/2013. ²As of March 31, 2013