International and emerging market (EM) fixed income present a way for investors to seek to overcome two challenges found today in U.S. fixed-income assets: low yields and high relative valuations. International bonds offer the potential for favourable yields—particularly in emerging markets—and lower relative valuations, and may be poised to outperform many U.S. fixed income assets in the current market environment.

Sovereign Bonds: Real Yields Higher Outside the United States

High real yields are available in many countries in the emerging world. Government bonds in most emerging markets are yielding an average real rate of 3.0%–3.5%, as opposed to almost zero in the United States. Many of these countries have also enacted structural reforms that have helped them become attractive investment destinations. At the same time, the United States is experiencing an environment of tightening monetary policy. EM real yields may serve as a cushion against rising U.S. interest rates.

The Case for International Bonds

EM Currencies Recovering; Still Undervalued in Our View

Over the past year, most major world currencies have appreciated against the U.S. dollar and are likely to continue to do so as stronger fundamentals in many emerging market countries help drive their respective currencies. The U.S. dollar, which peaked in 2015, remains approximately 15% above its long-term fair value, and we believe it will continue to weaken over the next two to three years. This may bode well for international fixed-income investors, as we expect that further appreciation of foreign currencies against the dollar will act as a tailwind for U.S.-based investors.

The Case for International Bonds

Corporate Credit Offers Better Value Internationally

Yields on bonds of similar credit quality to their U.S. counterparts are higher outside the United States, likely because the U.S. is at a more mature point in its economic cycle than the rest of the world. Corporate credit tends to be a good investment when growth is good and corporations are deleveraging. This was the case in the U.S. during the early phases of its growth cycle in 2009–2012. Now we find that same environment characterises the market of many international corporate bonds.

The Case for International Bonds

For the past eight years, falling currencies, high inflation and weak fundamentals dampened returns from fixed-income assets in emerging markets, and the European sovereign debt crisis of 2011-2013 weighed almost as heavily on international investors in developed markets. These headwinds have subsided and, thanks to their current higher real yields, strengthening non-U.S. currencies and improving credit conditions, we believe the environment for international fixed income offers reasons to consider increasing allocations to the asset class.