In their search for yield in an environment of low rates, some investors have ventured into emerging market bonds. Global bond funds which own emerging market bonds were the mutual fund category with the second largest inflows in 2011, $26 billion. And Templeton World Bond Fund had the largest inflows of any actively bond fund in any category, $11.9 billion. Diversified and single country emerging market ETFs bonds of all regions and countries have grown tremendously in number and assets under management.
The rationale for holding emerging market bonds is the large yield compared with US Treasuries. Proponents of the emerging market bonds point out that many of these emerging market countries have better fundamentals than the US in terms of GDP growth and domestic and trade surpluses. Implicit in the above economic assessment is the view that these favorable economic fundamentals make emerging markets less risky than US treasuries. I find this argument simplistic:, furthermore there are US$ alternatives in the bond market that have more attractive risk/return characteristics than the emerging market bonds.
Are emerging market bonds a worthwhile part of a portfolio's bond allocation? To make that decision I use my approach of "watching the spreads" and assessing risk and reward.
The purpose of a bond allocation in a portfolio is to provide a stable balance to the riskier assets in the rest of the portfolio. What I call the risk assets in a portfolio would include equities, commodities and some other alternative asset classes. The objective of the fixed income is a more stable asset class with the primary objective income generation, with some potential for capital appreciation but less volatility.
However, a review of the emerging market bond category shows that the risk characteristics of emerging market bonds are more akin to an asset that falls into the risk asset category. In fact these assets have an extremely unattractive profile: high risk with relatively low upside potential.
How to Assess Emerging Market Bonds:
First, the spreads. The attached table shows the country allocations, credit rating and duration of 3 of the major diversified emerging market bond ETFs compared to one intermediate US corporate bond fund and one high yield US bond fund.
ELD (local currency)
PCY (local currency)
Avg Credit quality
The Spreads: Emerging Markets vs. US Corporate Debt
As one can see from the table, the yield advantage vs. the US investment grade bond fund is minimal for the dollar denominated ETF while there is a yield differential ranging from .54% to .9% for the local currency denominated ETFs. Compared to the high yield bond ETF, the differential is negative.
In exchange for this small yield pickup the emerging markets bond investor is taking on considerable additional risk.
For the local currency denominated ETF: currency risk. The positive yield differentials vs. US$ bonds (including US Treasuries) could easily be wiped out by an adverse change in the value of the emerging market currency. Investing in the emerging market bonds is effectively another permutation of the "carry trade" used by hedge fund and other large capital market participantsin borrowed currency. As long as the yield differential remains higher in the invested currency and the exchange rate doesn't move against the invested currency, the trade is positive.
Although the emerging market bond investor is not borrowing to fund his purchase, he is taking the same risk: the exchange rate must remain stable or the invested currency strengthen to make the investment a successful means for earning the higher yield. Should the currency weaken, the currency depreciation will erase the yield differential. A small adverse movement in the local currency against the US dollar can wipe out the yield advantage. A short term movement of 2%, which can easily occur in a week, would more than wipe out that yield advantage anticipated for a 12 month period.
Currency movements are notoriously unpredictable, and often currencies of countries that may have different economic fundamentals may move in unison either because of impact across an entire region or even liquidation among all emerging currency asset classes. Many of the carry trades are leveraged and are in the same currencies as the EM ETFs. Therefore the momentum in a selloff can be quite severe as those positions are reversed and the individual emerging market bond investor finds himself on the wrong side of the currency movements.
Emerging market bond ETFs are that are denominated in foreign currency are diversified across currencies. But that diversification may not mitigate currency risk. Currencies within the same region often move in tandem. There is also the "contagion risk" in the emerging market currencies in which seemingly unrelated currencies decline in tandem despite different fundamentals. This occurred in the past with the Russian debt crisis. More on contagion risk below.
The investor in a local currency denominated ETF is taking a currency risk that trips up even the most sophisticated investors.
Emerging Market Bonds denominated in US dollars eliminate the currency risk but share in common several other major risks:
Political Risk: These countries, or at least many of them, have fragile regimes, a short history of democracy and free markets, or are currently not democratic or fully free market economies.. Potential for a change in political regime, economic system or domestic upheaval makes the bonds considerably more risky than US corporate bonds. Looking at the country allocations above it's not hard to see that such a risk already exists in Turkey, Russia, and Venezuela and has potential in many other countries.
Macroeconomic Risk: Some countries in the list above are facing the existence or prospect of inflation. This poses either of two possible outcomes, both negative. If the central bank moves to stall inflation and raise rates, this of course reduces the value of bonds. If the central bank is late to the party and lets inflation accelerat,e it will negatively affect the exchange rate as investors and trading partners seek to offset their decline in purchasing power (check purchasing power parity in any economics textbook).
Other countries depend on exports of either manufactured goods or natural resources. Thus they are subject to shocks in the world economy either in the form of fluctuations of commodity prices or reduced demand from their major export markets in Europe and the United States. Still others are commodity importers and could suffer when some commodity prices rise.
Liquidity Risk - In most cases increased assets in an ETF or its underlying asset class is a positive factor for liquidity. However in the case of emerging markets the opposite may be the case. Ultimately the ETF flows must be reflected in the underlying bond market. Should political upheaval, major exchange rate changes, or other factors lead to everyone running for the exits from a particular country or region's bond market, it won't be pretty. These relatively thin, illiquid and relatively undeveloped markets will experience sharp and rapid price declines.
"Contagion Risk" - As noted above, the country diversification of these instruments is misleading as an indication of risk. Not only could a crisis affect bonds and currencies of other countries in a particular geographic, the effect could occur in countries with nothing in common geographically or economically.. This occurred during the Russian debt crisis when Singapore halfway around the world and with a strong currency suffered major outflows. When emerging markets are sold off as an asset class, all suffer.
The growth of ETFs and mutual funds in this asset class will increase the cross correlation of bonds in this category across the world as they are traded as a basket. This has been a trend among individual stocks in the US. I have little doubt a sharp selloff in emerging market bonds will take them all down in price regardless of differences in fundamentals. After all, this already happens to a large degree in emerging market stocks.
Taking all these factors into consideration as well as the low level of spreads versus both treasuries (around 2%) and minimal or negative spreads against various ratings of corporate bonds, it's hard to believe the upside on these bonds is very great from any further narrowing of the spreads - in fact in my view many are already overvalued. For example Mexican 10 year bonds are at 1.40% spread over US Treasuries.
The credit rating of these bonds represents a limited view of risk. It reflects the view of whether the current conditions indicate that the sovereign entity issuing the bonds has the likelihood of meeting its debt obligations. It is not an assessment of the risks described above. The credit rating is not an exchange rate, interest rate or inflation forecast. And it doesn't take into account liquidity or contagion risks described above.
Thus the upside potential for price appreciation on these bonds is minimal yet the downside is considerable. A best case scenario would be stable interest rates and an opportunity to reap the benefits of the narrow interest rate advantages.
What about the argument in favor of these bonds due to superior economic fundamentals vs. the US? This argument is more theoretical than practical. Global crises lead to a move towards, not away from, US treasuries despite some ugly fundamentals for the US. The US Treasury market rallied tremendously since the downgrading of its credit. As the European economic crisis accelerated, US treasuries experienced massive inflows and price increases.
My conclusion about Emerging Market Bonds? They don't deserve a place as part of the bond allocation of a portfolio which seeks steady income and moderate price fluctuations. In fact the risk outweighs the potential return even if these bonds are considered "risk assets" or "alternative" assets.
If one wants to participate in the economic growth of the emerging markets, investors are far better off putting the money in stocks. The above stated risks certainly exist to take prices down. But there is an upside limit to the gains on the bonds either through spreads narrowing or rates falling. In contrast the potential gains in emerging market stocks is unlimited and although certainly volatile can be considerable, to say the least.
Additional disclosure: Mr. Weinman's clients have positions in HYG and VCIT