Hard currency versus local currency EM bonds: What is the difference?

Hard currency versus local currency emerging markets bonds: What is the difference?

Emerging market (EM) bonds come in two main types: Hard currency bonds are issued in US dollars or another major reserve currency such as euros, while local currency bonds are issued in the home currency of the issuing country. Both give investors access to faster-growing emerging economies with yield profiles that are difficult to replicate in developed markets, but they carry different risk characteristics and respond differently to market conditions. It is useful to understand the difference.

What are hard currency emerging market bonds?

When investors talk about hard currency bonds, they are almost always referring to bonds issued in US dollars. A hard currency EM bond is a bond issued by an emerging market government or corporation but denominated in US dollars or another major reserve currency such as the euro. Emerging market issuers borrow in dollars because it broadens their investor base as most global investors are comfortable holding hard currency denominated assets. A government like Brazil or Indonesia, for example, may issue bonds in US dollars specifically to access that demand, but collects its revenues in local currency, creating a currency mismatch between what it earns and what it owes.

What are local currency emerging market bonds?

A local currency EM bond is a bond where both interest payments and principal repayment are made in the issuing country's own currency, like the Indonesian rupiah, the South African rand, or the Brazilian real. When buying a local currency bond, a US-dollar-based investor’s return depends on two things: the bond's yield and how that currency moves against the US dollar. That currency exposure introduces both risk and opportunity. If the local currency weakens against the dollar, it can reduce your return even if the bond itself performed well. But if it strengthens, investors earn additional return on top of the bond yield, a source of upside that does not exist in a domestic bond portfolio. Currency strength in emerging markets is typically driven by a country’s underlying fundamentals: economic growth, commodity prices, and monetary policy. When those fundamentals improve, the currency tends to follow.

How do currency movements affect your return?

When you invest in a local currency bond, your return depends on the bond’s local-currency total return and the currency move against the US dollar.

Here is a simple example of how that plays out. Assume a 7% local-currency bond total return before currency movements. A 5% currency decline results in an approximate 2% currency-adjusted return, while a 5% increase results in an approximate 12% currency-adjusted return.

Currency movement impact on returns

Source: VanEck. Assumed variables illustrate mathematical principles only and do not predict or project the performance of any investment or strategy. Results are rounded to the nearest whole percentage point. This example does not represent actual investment results, and fees, expenses and taxes are not reflected.

What is the key difference between hard currency and local currency emerging markets bonds?

While both types give investors access to emerging market debt, they differ in ways that can impact a portfolio's risk and return.

• Currency risk: Hard currency bonds carry lower foreign exchange risk for developed market investors. Because they are denominated in a currency like the US dollar, they can be hedged back into the local developed market currency so that returns are not directly affected by movements in the issuing country's exchange rate. Local currency bonds expose investors directly to those movements, which have a key distinction that shapes how each type behaves in a portfolio.
• Credit risk: Although hard currency bonds are not directly impacted by a local currency’s value, the issuing country’s ability to pay is. If a currency weakens, the country must still meet its obligations in the currency the debt is issued, and therefore credit risk increases. In addition, smaller, less developed countries generally have more difficulty raising capital from global investors in local currency and more often will look to hard currency markets, and as a result, the hard currency benchmark has a higher weighting towards non-investment grade countries.
• Yield: Local currency bonds typically offer higher yields to compensate investors for taking on additional currency risk, all else equal (as mentioned above, all else is typically not equal, since hard currency benchmarks tend to have a higher weight toward non-investment-grade borrowers). For income-focused investors, this yield premium is often the primary draw, and it is a level of income that is difficult to replicate in developed market fixed income. However, this is not always the case; local economic conditions and how policymakers respond to them will impact local rate levels, and they can be higher or lower than hard currency counterparts.
• Who issues them: Both hard currency and local currency bonds are issued by governments and corporations across emerging markets. The difference is the currency in which the bond is issued, not the nature of the issuer or the underlying credit.
• Who buys them: Hard currency bonds may appeal to investors who do not want to take direct exposure to emerging markets' foreign currency movements. Local currency bonds tend to attract investors who are seeking currency diversification, higher income potential, or exposure to the long-term trajectory of emerging market economies. The local currency market is larger because many emerging markets have large, liquid domestic investor bases that generate demand for the bonds.

Hard currency emerging markets bonds versus local currency emerging market bonds

Source: VanEck. Generalised comparison for illustrative purposes only. Actual characteristics may vary by issuer, country and market conditions. The J.P. Morgan EMBI Global Diversified Index tracks US dollar-denominated emerging markets bonds. The J.P. Morgan GBI-EM Global Diversified Index tracks local-currency emerging markets government bonds. Indices are unmanaged and cannot be invested in directly.

What are the risks of each type?

Hard currency risks:

• Dollar strength - A stronger US dollar or euro can make it harder for emerging market issuers to repay their debt. This can be reflected in wider credit spreads, negatively impacting market values.
• US interest rates - Hard currency bonds carry the same interest rate sensitivity as any US dollar bond, as they are directly exposed to US bond yields and US monetary policy. When US rates rise, bond prices fall. The same dynamic would be true for bonds issued in euros. Investors should be aware of this duration risk when building a position. 

Local currency risks:

• Currency moves - If the local currency falls against the dollar, it can reduce total return even if the bond itself performed well. This is the most important risk to understand before investing in local currency EM bonds.
• Currency volatility - Exchange rates can move quickly.
• Country risk: Political or economic instability in the issuing country applies regardless of what currency the bond is denominated in. A well-diversified approach across countries and issuers is the most effective way to manage this exposure.

What are the benefits of local currency emerging markets bonds?

1. Higher income potential. Local currency bonds often offer higher yields than bonds from developed markets. For income-focused investors, this yield premium is often the primary reason to consider them.
2. Currency upside. If the local currency rises against the US dollar, investors earn additional return on top of the bond yield. Investors holding assets in foreign currencies gain when the dollar loses value relative to those currencies.
3. Stronger government finances. Many emerging market governments carry lower debt levels than developed market peers like the US or Europe. For some countries, that can mean a more stable borrowing environment over time and provide support to the local currency.
4. Improving monetary policy. Many emerging market central banks have adopted more disciplined monetary policy frameworks in recent years. That shift has helped reduce some of the volatility that historically made these markets harder to navigate. Similar to disciplined fiscal policy, this can help support the local currency as inflation expectations are kept in check.

Accessing emerging market bonds

Because of the idiosyncrasies between the nations included in the emerging markets universe and the nuances between the different types of bonds available, we think an active, unconstrained approach that can access both hard and local currency bonds, like the one employed by the VanEck Emerging Income Opportunities Active ETF (EBND) , is an ideal way for investors to access this important asset class.

Key risks

An investment in the Fund carries risks associated with: ASX trading time differences, emerging markets bonds and currencies, bond markets generally, interest rate movements, issuer default, currency hedging, credit ratings, country and issuer concentration, liquidity, fund manager and fund operations. See the VanEck Emerging Income Opportunities Active ETF PDS and TMD for more details.

EBND is likely to be appropriate for a consumer who is seeking capital growth and a regular income distribution, is intending to use the product as a minor or satellite allocation within a portfolio, has an investment timeframe of at least 5 years, and has a very high risk/return profile.