The Income Hunt: Opportunities Abroad

Includes: EMB, LEMB
by: Russ Koesterich, CFA

Investors often have a home country bias when it comes to their fixed income portfolios, which means they are generally too reliant on domestic issues. Today, however, there are a number of reasons why investors should consider maintaining a strategic benchmark allocation to emerging market debt.

In recent posts, I’ve highlighted some of these arguments, including the increased stability and improving fundamentals of emerging market countries. But since so many investors are asking me lately about emerging market debt, I figured I’d expand on the case for this asset class in this post. Here’s a bit more on four arguments favoring exposure to emerging market fixed income.

Better fiscal positions: Emerging markets exited the financial crisis in a far better position than their developed market counterparts. The average debt burden of emerging markets is less than 40% of gross domestic product, while developed market debt has soared to more than 100% of GDP on average. This greater fiscal stability is partly why emerging market bonds should now be less volatile relative to their developed counterparts than in the past.

Fading inflation risk: While investors in emerging markets were reasonably concerned about inflation in 2011, inflation appears to be a fading risk in most of the large emerging market countries, the exception being India. Chinese inflation is currently running at 3.6%, roughly half the level of last July. In Russia, inflation has fallen to 3.7% in March from nearly 10% last May. Even in Brazil, a country with a history of stubbornly high inflation, consumer price inflation has dropped to 5.2% in March, down from 7.3% in September. International Monetary Fund estimates suggest that this trend should continue, with emerging market inflation expected to fall throughout 2012.

High premium: Despite emerging markets’ improving fundamentals, emerging market bonds are offering a significant, and historically high, premium over most developed market debt. Currently, emerging market bonds are yielding roughly 350 basis points over the 10-year Treasury, close to a record high.

Diversifying hedge: Emerging market bonds add diversification and a hedge on the dollar, although they are more volatile than domestic bonds. And for those wishing to avoid the foreign currency exposure associated with international bonds, there are dollar denominated emerging market bonds and funds that offer the incremental yields without the foreign currency risk.

In short, most investors are arguably underweight emerging market bonds in their fixed income portfolios though there’s a strong case for considering increasing exposure to this asset class through vehicles such as the iShares J.P. Morgan USD Emerging Markets Bond Fund (NYSEARCA: EMB) and the iShares Emerging Markets Local Currency Bond Fund (NYSEARCA: LEMB).

Source: Bloomberg

Disclosure: Author is long EMB

Diversification may not protect against market risk. Bonds and bond funds will decrease in value as interest rates rise. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Narrowly focused investments typically exhibit higher volatility and are subject to greater geographic or asset class risk. The Fund may be subject to credit risk, which refers to the possibility that the debt issuers will not be able to make principal and interest payments.