By Carla Fried
The state of the U.S. bond market is actually worse than it appears. The obvious problem is that nominal interest rates are about as low as Lindsay Lohan's popularity score. If you're parked in U.S. Treasuries, you're not exactly getting paid much.
High-grade corporate bonds aren't exactly delivering a ton of income either.
To be clear, that Moody's index is for bonds with a 30-year maturity. Ratchet down to a less volatile 10-year AAA corporate bond, and you're looking at a 2.6% yield. Those low nominal yields are bruising enough, but the real kick to the gut is that after adjusting for inflation, Treasuries have a negative yield, and corporates aren't paying you much for taking on some credit risk.
For real (inflation adjusted) returns, you need to expand your bond horizon abroad. Without dabbling in the economic headcases in the Euro zone there are some growing, fiscally sound(er) countries delivering real yields.
•Mexico's 10-year government bond yields 5.5% and inflation is 3.8%.
•Brazil's 10-year is at 12% and inflation is at 5%.
•South Korea's 10-year bond is at 3.6% and inflation is 2.1%.
•South Africa's 10-year bond yields 8.2% and inflation is 5.7%.
Yep, we're talking emerging market bonds. Risky? Yes and no. The "yes" has to do with any foreign investment: currency risk. Unless you hedge your position or the foreign bond is dollar-denominated, you're going to get smacked a tad when the U.S. dollar rises, as it has for the past year. The "no" part of the answer has to do with the fact that as "risky" as you may perceive emerging markets to be, the reality is their balance sheets are in a lot better shape than what many big developed countries are dealing with. (Exhibit A: The United States, which is still pumping out some sickly economic indicators. Exhibit B: Much of developed Europe.)
That's not to suggest you bail on a core U.S. bond portfolio. But adding a small slice of emerging market bond exposure can get you both a higher yield today and better underlying fundamentals that could help future returns. A country that has a growing economy and real interest rates has room to lower rates going forward; that pushes up prices and boosts total return.
There are a variety of Exchange Traded Funds (ETFs) that focus on emerging market bonds.
WisdomTree Emerging Market Local Debt (ELD) gives you unhedged exposure to bonds from 15 different emerging market economies. It yields 3.8%. The iShares JP Morgan USD Emerging Markets Bond ETF (EMB) removes the currency risk; its current yield is 4.4%.
Given the dollar's recent strength, the hedged fund has rocked the past year.
If your goal is to minimize volatility, hedging is the way to go. Just keep in mind a few things. First off, the recent strength of the U.S. dollar is a reaction to current global economic concerns. But long-term a strengthening dollar doesn't seem probable, given our deficit and debt concerns. Studies have shown that while an unhedged bond portfolio is definitely more volatile, over time, it also has produced better total returns.