What Are Local Currency Emerging Market Bonds?

Currency risk is also known as FX risk. FX stands for "foreign exchange." It's the risk that an investment that's denominated in a foreign currency will lose value as the currency itself loses value against the U.S. dollar.

But the opposite can also happen. It will add to your positive return if a foreign currency increases in value against the dollar. Emerging market bonds are an interesting example.

Emerging Market Bonds: Dollar Denominated vs. Local Currency

You have two options when it comes to investing in emerging market bonds. The first is to invest in the dollar-denominated debt issued by the world's developing countries. Dollar-denominated simply means that the bonds are issued in U.S. dollar terms. You don't have to convert to foreign currencies when you purchase them. There's no impact from currency risk on top of the ups and downs associated with emerging market bonds.

Bonds that are denominated in local currencies rather than U.S. dollars are the second type of emerging market debt. You'll have to convert dollars to foreign currency in this case prior to buying the bond. In addition to the price movement of the underlying bond, the value of the investment is affected by the rise or fall of the foreign currency/U.S. dollar exchange rate.

Suppose you buy $1 million worth of Brazil's local currency debt. But you first have to convert your dollars into the local currency. The price of the bond is exactly the same a year later, but the currency has depreciated 5% versus the dollar.

That 5% depreciation leads to an extra 5% loss in value when you sell the bond and convert back to U.S. dollars. This is the case even though the nominal price of the bond in reals is unchanged.

Dollar or Foreign-Currency Denominated?

The right fit for you depends on your own needs. The benefit of local currency funds is twofold. First, it allows you to diversify your holdings away from the U.S. dollar. Second, it allows you to benefit from the positive effect of emerging market nations with stronger economic growth.

Currency exposure adds another layer of volatility at the same time. This becomes a bigger factor during times when you're looking to avoid risk. It makes sense to expect that local currency funds will underperform their dollar-denominated counterparts. Dollar-based debt may be the better option in times of uncertainty for new investors in the asset class or for those with lower risk tolerance.

How Performance Differs

Growing concerns about the European debt crisis sparked a flight from higher-risk assets in September 2011. EMB (the emerging markets ETF that holds dollar-denominated debt) returned -4.9% in the midst of this selloff. ELD holds local currency debt. It returned -10.2% at the same time, a big difference in such a short period.

ELD returned 7.6% and trounced EMB's return of 2.1`% during the first two months of 2012, a very positive period for the markets. But the contrast tends to even out over time.

You Have Many Options

You have to make a choice between dollar-denominated or local-currency bond funds (or establish some desired combination of the two) if you're looking to allocate a portion of your portfolio to foreign bonds. Some fund companies offer both. PIMCO offers both the PIMCO Emerging Markets Bond Fund (ticker: PEBIX) as well as the PIMCO Local Emerging Bond Fund (PELBX).

The Bottom Line

Many funds are managed to move between dollar- and local-currency-denominated bonds. Look deeply into any bond fund investment to make sure you understand the currency denominations of the bonds in its portfolio. Confirm that the fund fits your risk profile and that it works with your overall investment plan.

Frequently Asked Questions (FAQs)