Emerging market debt may benefit from US dollar reallocation

Market analysts suggest that a gradual reallocation of capital away from concentrated US dollar assets could provide momentum for emerging market debt. Denise Simon, Co-Head of the Emerging Markets Debt team at Lazard Asset Management, notes that robust fundamentals and attractive yields support this asset class, though a restrictive US Federal Reserve and a resilient US dollar remain primary challenges for local currency bonds.

In the second quarter, emerging market debt segments showed recovery, with US dollar-denominated sovereign and quasi-sovereign bonds achieving a 4.63 percent return. Local currency bonds rose by 3.85 percent in US dollar terms, despite pressure from a stronger dollar in June.

Concurrently, concerns are rising regarding unhedged US dollar exposures in fixed-income funds. Many institutional investors have reduced currency hedging on US equities, bonds, and real estate to boost short-term reported returns. While this acts as a leverage mechanism during periods of dollar strength, a reversal in exchange rates could trigger mark-to-market losses and liquidity requirements through margin calls, potentially leading to selling spirals.