5 Ways To Increase Profits From An Emerging Markets Bond Pro

Includes: ELD, EMB, PCY
by: Learn Bonds

I recently sat in on a presentation by Luz Padilla who manages the DoubleLine Emerging Markets fund. In the presentation she gave 5 concrete examples of how investors can increase the profitability of their emerging market bond investments. The 5 examples are:

1. Think about emerging market bonds as 3 distinct categories.
2. Look at new issues from old companies that have not issued in a while.
3. Look for long-term issues being issued to retire shorter-term debt obligations.
4. Go with a shorter duration than the index.
5. Hedge your portfolio with shorter-term credits in case of crisis.

Here is my explanation of each:

Think about emerging market bonds as 3 distinct categories.

Most of the time when you hear people talk about emerging market bonds, they do not differentiate between the different types of emerging market bonds. At DoubleLine they view the emerging market bond space as having three distinct categories:

  1. Sovereign emerging market debt, which is debt issued by governments.
  2. Local currency corporate debt, which is debt issued by companies denominated in the currency of that country.
  3. Dollar denominated corporate debt which is debt issued by companies that instead of being issued in the local currency, is denominated in US Dollars. Companies do this because it makes the debt more attractive to foreign investors. Typically the US dollar is also much less volatile than emerging market currencies, removing some volatility for foreign investors as well.

Luz says that when people talk about emerging market bonds being overvalued, they are normally focused on the sovereign sector of the market. This is also where many institutional investors have focused their attention, because the emerging market sovereign bonds are closer substitutes for investment grade bonds here in the US. As the Fed has crowded people out of the US investment grade space, they have moved to emerging market sovereign bonds as an easy substitute. Just because Brazil's sovereign debt looks expensive, however, does not mean that Brazilian corporate bonds are overvalued.

Look at new issues from old companies that have not issued in a while.

As you can see from the below chart, the majority of the DoubleLine Emerging Markets bond fund is invested in emerging market corporate bonds.

How the DoubleLine Emerging Markets Bond Fund is positioned currently

In addition to feeling that dollar denominated emerging market corporates have the best value overall, Luz gave some specific advice as to where they are finding exceptional value.

Currently, Luz and her team are finding great deals from credible issuers that have not issued bonds for a number of years. Even though these issuers have a long history and solid fundamentals, because they have not made a recent issue, many investors are not familiar with them. As a result, these companies have to pay a higher interest rate to attract buyers.

Because Luz's team has been investing in emerging markets for many years, they are familiar with pretty much every credible issuer in the space. They therefore recognize the potential to earn a higher rate of return, from companies that are the same credit risk as ones with lower yields.

Look for long-term issues being issued to retire shorter-term debt obligations.

Another place that Luz and her team are finding value in the dollar denominated emerging market corporate bond space is from issuers who are extending their maturity profile. This means that they are issuing longer-term bonds to take advantage of the low interest rate environment we are currently in, and using the proceeds to pay off any shorter-term bond issues that they have.

After doing so the company has a longer period of time to pay off the same amount of debt, which often makes the company less likely to default. While Luz did not go into detail on why this is happening, she says that currently this lowering of risk is not factoring into the equation when the new longer term bonds are being issued. Because of this, the longer term bonds are offered at a higher yield than they should be in the primary market, and then immediately start trading at a lower yield when they come into the secondary market. This gives the bonds a nice pop in value immediately after Luz and her team purchase the bonds in the primary market.

Go with a shorter duration than the index.

A popular emerging markets bond index is the JPMorgan EMBI Global Diversified Index. As a result of the low interest rate environment, and as discussed above, many issuers are extending their maturity profiles. As a result, the average duration and interest rate risk in emerging markets is also increasing. This reflects in the index which now has a duration of 7.32.

Because interest rates are so low globally right now, the risk is definitely skewed towards interest rates rising. This, combined with the fact that you are getting very little additional yield in longer term bonds, means that investors should look to lower their duration in comparison to the index.

Luz and her team are practicing what they are preaching here, as the DoubleLine emerging markets fund has a duration of 4.66, significantly lower than the index.

Hedge your portfolio with shorter-term credits in case of crisis.

In addition to helping to lower the duration of your emerging market bond portfolio, investing a portion of the portfolio in short-term bonds gives you a lot of flexibility. If there is a crisis or other reason that causes emerging market yields to spike, your short-term bonds should not be affected as much as your longer-term bonds. Secondly, because they mature faster, the money invested in your short-term emerging market bonds will be freed up faster so you can take advantage of higher yields as they present themselves.

So, which emerging market bonds should you be looking at?

As far as industries, Luz likes getting exposure to industries that make the economy tick. As you can see from the graph below, they are currently invested heavily in sectors like banking and mining, two keys to the success of many emerging market economies.

You can see which countries Luz feels there is the most value currently by looking at the country breakdown of The DoubleLine Emerging Markets Bond fund below:

How can investors take advantage of these opportunities?

If you like what you are reading above, then the easiest way to get exposure is to invest in the DoubleLine Emerging Markets Fund (MUTF:DLENX). If you would like more flexibility then you can also check out some of the emerging market bond ETFs like the EMB, PCY, and ELD. Unfortunately, however the emerging market ETFs are still pretty broad based in terms of the exposure that they are giving. With this in mind if you want exposure to specific markets, and to manage the portfolio yourself, you are likely better off going with a broker that can provide access to emerging market bonds. Examples would be Peter Schiff's Euro Pacific Capital and EverBank Direct.

Bill Gross is another bond pro who has been talking about emerging markets a lot recently. Read what he has to say here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.