In a search for higher yield, many investors have turned to more exotic asset classes such as Emerging Market [EM] bonds. This article will compare the risks and rewards of EM bonds versus more conventional US treasuries and corporate bonds. At the end of the article, I will show one way to combine US and EM bonds into a high-return, low-risk bond portfolio.
There are many measures of risk. Interest rate risk is a key metric, especially with bond funds. However, over the last several years, interest rates have been driven by quantitative easing policies of the Federal Reserve rather than by market forces. This makes it difficult, if not impossible, to quantify when interest rates might begin to rise. Therefore, for this analysis, I will define "risk" as the historical volatility of an asset over a period of time.
The bear market of 2008 started on 9 October, 2007. Emerging market funds, along with most other assets, did not fare well during this selloff. The Powershares EM Sovereign Debt (NYSEARCA:PCY), was the only emerging market bond ETF in existence when the bear market began. The NAV of PCY dropped over 14% in 2008, but the price dropped over 19%. It is unusual for ETFs to sell at substantial discounts to their NAV but, as evidenced by 2008, this can happen when liquidity dries up and it becomes difficult for arbitrageurs to keep prices in line with NAV. Closed End Funds (CEFs) of emerging market bonds performed even worse than PCY, with the prices of many of the EM CEFs falling by more than 25%. All these assets subsequently recovered in 2009 and have been in a bull market ever since.
To capture the full risk-reward cycle, this analysis only considered ETFs and CEFs that were available in October, 2007 (about a 5.5 year period).
Emerging market bond funds typically have a mix of both government and corporate bonds and have similarities to the high yield US bonds. Therefore, for reference, I compared the performance of the EM bonds to the following US bond ETFs:
- iShares Barclay 20+ Treasury Bonds ETF (NYSEARCA:TLT) This fund consists of long term treasuries. It is one of the few asset classes that did well in 2008, gaining over 33% (but gave back over 20% in 2009).
- iShares Barclay 7-10 Year Treasury Bond ETF (NYSEARCA:IEF). This fund consists of intermediate term treasuries. It also racked up impressive gains of over 17% in 2008 (followed by a loss of over 6% in 2009).
- iShares iBoxx $ Investment Grade Corporate Bonds (NYSEARCA:LQD) This fund has about 67% intermediate term corporate bonds and the rest in long term. It was roughly even in 2008 and had good returns in 2009.
- iShares iBoxx $ High Yield Corporate Bonds (NYSEARCA:HYG) "Junk" bonds were devastated in 2008 with the price of HYG falling over 17%. The NAV fell even more (23%) but quickly recovered in 2009.
I also wanted to see how the performance of bond funds compared with equity funds so I included statistics for the SPY, the SPDR S&P 500 ETF.
Table 1 summarizes the ETFs and CEFs that I used for this analysis. In Figure 1, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu on the charts) versus the volatility for each of the assets. The Smartfolio 3 program (smartfolio.com) was used to generate this chart. Table 1 also provides the distribution rates and some notes on whether the fund is a CEF or ETF and if it sells at a premium.
Table 1: Emerging Market Bond Fund Data over 5.5 Years
Figure 1: Emerging Market Fund Risk-Reward over 5.5 Years
As you would expect, over the past 5.5 years, the reference ETFs exhibited both lower volatility and lower rate of return than the Emerging Market bonds. Emerging Market bonds have lived up to the promise of higher returns but at the price of significantly more volatility. To assess if the reward was worth the risk, I calculated the Sharpe Ratio for each asset.
The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe, that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility (the reward-to-risk ratio if you measure "risk" by the volatility). It is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. The Sharpe Ratios are tabulated in Table 1.
Analyzing these Sharpe Ratios provided some additional insights. Due to their performance in 2008, investment grade corporate bonds (LQD) provided the best risk-adjusted return followed by long term treasuries, TLT. For comparison, SPY has a Sharpe Ratio of about .16, so bonds of all types have done substantially better than stocks over this market cycle. Among the EM assets, GHI (NYSE:GHI), TEI (NYSE:TEI), SBW (NYSE:SBW), and PCY have performed best in terms of reward-to-risk.
Data for the 3 year time frame is summarized in Figure 2 and Table 2.
Figure 2: Emerging Market Fund Risk-Reward over 3 Years
Table 2: Emerging Market Fund Data over 3 Years
This data indicates that during the bull market, all the funds improved their reward-to-risk ratios except for GHI, which has struggled. Several observations stand out when we analyze this data:
- During a bull market, the EM bonds (except GHI) have had excellent risk-adjusted returns, handily beating the SPY on a risk adjusted basis.
- The reference ETFs are still clumped in the lower-return, lower-risk region except for TLT which has had a phenomenal run in terms of total return. The risk associated with TLT has also increased dramatically but the Sharpe Ratio is still relatively high.
- PCY has been exceptionally stable while delivering a good total return of over 9%. A similar statement can be made for investment grade corporate bonds. PCY and LQD have by far the best Sharpe Ratios.
- ESD and LBF have the best risk-adjusted return of the Emerging Market CEFs that were analyzed.
The second part of my analysis was to assess how well these bond funds have provided diversification. To appraise the degree of diversification, I calculated the pairwise correlation coefficients among the assets over the last three years. Several interesting observations were:
- For the reference US bond funds: TLT, IEF, and LQD are highly correlated with each other but negatively correlated with the SPY. So, as you would expect, buying these bond ETFs do provide a way to diversify and hedge risk against equities. On the other hand, HYG is more attuned to equities and has a high correlation (80%) with the S&P 500.
- The emerging markets bonds are moderately correlated with each other and to the SPY (50% to 60% range). Therefore, EM bonds are not as good as US bonds in providing diversification against the equity market (but are still better diversifiers than many other asset classes). Of all the EM funds, PCY has the lowest correlation among both peers and the SPY.
Putting this all together, I assembled a simple portfolio of US bonds and EM bonds. This portfolio consisted of equal weights of PCY, LQD, (NYSE:LBF), ESD, and IEF. The results are shown in Figure 3. Notice that I combined some relatively high-return, high-risk assets with low-return, low-risk assets. Taking advantage of diversification, the resulting composite portfolio has a good return (over 10%) combined with a very low volatility (less than 6%). The resultant Sharpe Ratio is an excellent 1.76.
Figure 3: A High-Return, Low-Volatility Bond Portfolio
I do not make any claim that this is the "best" portfolio or that it will keep performing at this level in the future, but I personally like the potential reward-to-risk and have implemented this in my investment account.
Disclosure: I am long PCY, LQD, LBF, ESD, IEF, EMB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.