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Emerging Markets Fixed Income & The U.S. Dollar

Emerging Markets Fixed Income & The U.S. Dollar by Bradley Krom, Fixed Income & Currency, The Wisdom Tree Blog

While we remain firm believers in the long-term potential of emerging markets (EM), the past several years have been difficult due to increasing volatility and secular headwinds from a strong U.S. dollar. In a previous post, we sought to introduce a more cost-effective hedge for emerging market investing. In our view, a bullish dollar position against a broad-based basket of developed and emerging market currencies provides a powerful option for managing currency risk in a portfolio of emerging market assets. In the discussion below, we put this concept in practice by combining a bullish dollar strategy1 with an emerging market local debt strategy.2 In our view, emerging markets provide some of the most compelling valuations around the world. Employing a bullish dollar strategy as a hedge for EM currency risk could be a cost-effective way to reduce volatility, particularly in advance of a shift in Federal Reserve (Fed) policy.

The “Dirty” Hedge in Practice

In 2014, of the 55 major currencies that WisdomTree tracks, none appreciated against the U.S. dollar.3 In our view, during periods of broad-based dollar strength, dirty hedges can be a particularly valuable tool. As we show in the chart below, a 50/50 allocation of a bullish dollar strategy and EM local debt has significantly improved the risk/return profile of emerging market fixed income investing.

A Blended Approach to Currency Risk

50% EM Local Debt/ 50% Long-Dollar. (3/31/11-6/30/15)

In this blended approach to emerging markets, investors are able to maintain exposure to the emerging market assets while dampening the overall drawdowns and volatility of their investment. As we have seen so far in 2015, emerging markets can experience volatility on the upside as well as the downside.4 By combining legacy EM fixed income...