Emerging market (EM) bonds have been one beneficiary of today’s low yield environment.
As investors casted a wider net for income, flows into emerging market bond exchange traded products (ETPs) doubled from 2011 to about $6 bn last year. Meanwhile, yields on local currency bonds issued by emerging market governments are now at 5.9%, down from 6.8% last March.
But now, after emerging market bonds’ rally, is it too late to allocate to this asset class? In my new Market Perspectives piece, I share three reasons why I believe emerging market debt is still worth considering:
- EM debt adoption. While most investors have embraced emerging market equities, they have been slower to adopt emerging market bonds, meaning the market isn’t yet overcrowded. Among institutional investors, ownership of emerging market debt is still extremely low. The largest defined benefit plans, for instance, have allocations to international debt in general of around 2%, and among retail investors, current allocations to emerging market debt are negligible. In addition, last year’s flows into emerging market bond ETPs made up just a small amount of the roughly $57bn total flows into fixed income ETPs.
- EM vs. DM fundamentals. Compared to developed markets (DM), emerging markets are experiencing faster growth and by many measures – particularly fiscal – greater macroeconomic stability. In fact, the big story in emerging market debt is an improvement in credit quality – both in an absolute sense and relative to developed market issues. Over the past two decades, many emerging market countries have made significant improvements to their fiscal positions and can now boast more pristine balance sheets than most developed markets.
- EM vs. DM yields. EM debt generally now offers higher yields than developed market bonds. And while emerging market debt yields have dropped in recent years, the size of the drop has been much less precipitous than that of developed market yields. In addition, emerging market bond spreads are still wide relative to US Treasuries. This means there’s further room for spread compression as emerging market asset quality and fiscal credibility continue to improve.
That all said, emerging market debt is still a volatile asset class when compared to more traditional fixed income investments. As such, allocations to this asset class will largely be a function of an investor’s individual risk appetite.
While more conservative investors will probably want to avoid any significant positions to emerging market debt, more aggressive investors with high-income needs may want allocate 10% to 30% to emerging market debt rather than going out to the extremes of the US yield curve.
Source: April Market Perspectives, US ETP Landscape
Disclaimer: Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. 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.