It’s turning out to be a great year for emerging debt. Returns on sovereign dollar bonds have topped 10 percent already this year on the benchmark EMBI Global index, compiled by JP Morgan.  That’s better than any other fixed income or equity category, whether in emerging or developed markets. Total 2012 returns could be as much as 12 percent, JPM reckons.

Debt denominated in emerging currencies has done less well . Still, the main index for local debt, JPM’s GBI-EM index, has  racked up a very respectable 7.6 percent return year-to-date in dollar terms, rebounding from a fall to near zero at the start of June.  Take a look at the following graphic which shows EMBIG returns on top:

Fund flows to emerging fixed income have been robust. EPFR Global says the sector took in  $16.2 billion year to date.  JPM, which tracks a broader investor set including Japanese investment trusts, estimates the total at $43 billion, not far off its forecast of $50-60 billion for the whole of 2012.

So what’s driving this stellar performance?

For one, emerging yield spreads over underlying U.S. Treasuries have tightened over 60 basis points since the start of the year, reflecting investors’ appetite for emerging markets exposure. Second, U.S. Treasuries.  Outright yields on the EMBIG are calculated as a spread over Treasuries which have risen since the start of the year. Third, the dollar has performed strongly versus other currencies.

The dollar’s resilience is the reason why investors this year are favouring emerging dollar debt to bonds in local EM currencies such as the rand and zloty — JPM estimates 80 percent of the fixed income flows it tracks have gone to dollar debt this year. Emerging currencies on the other hand have been volatile and big bond issuers such as Brazil and Indonesia have seen significant currency losses against the greenback. Hardly an inducement to dip into those debt markets.