Emerging-Market Bonds Are Hot … Too Hot!

by Daniel Putnam | September 13, 2012 6:45 am

Emerging-Market Bonds Are Hot … Too Hot!

Emerging-market bonds don’t get much attention. They don’t fit neatly into a typical portfolio, they’re not as sexy as their equity counterparts, and they still have a questionable reputation after their periodic meltdowns of the past two decades.

Still, a look at the results shows something that might surprise many investors: In the 10 years through Aug. 31, emerging-market debt has beaten virtually every other major asset class.

Asset Class / Index 10-yr Avg. Annual Return (8/31/12)
Large-Cap U.S. Stocks (Russell 1000 Index) 6.86%
Small-Cap U.S. Stocks (Russell 2000 Index) 9.00%
Developed-Market International Stocks (MSCI EAFE Index) 6.67%
Emerging-Market Stocks (MSCI Emerging Markets Index) 15.00%
Investment-Grade Bonds (Barclays Aggregate U.S. Index) 5.48%
High-Yield Bonds (Credit Suisse High Yield Index) 10.26%
Emerging-Market Bonds (JP Morgan EMI Global Diversified Index) 11.41%

Despite this, the largest ETF that invests in emerging-market bonds — the iShares JPMorgan USD Emerging Markets Bond Fund (NYSE:EMB[1]) — has just $5.3 billion in assets. In comparison, iShares MSCI Emerging Markets Index Fund (NYSE:EEM[2]) has $34.4 billion, while the two largest high-yield bond ETFs — iShares iBoxx $ High Yield Corporate Bond Fund (NYSE:HYG[3]) and SPDR Barclays Capital High Yield Bond ETF (NYSE:JNK[4]) — have a total of $28.1 billion.

The disconnect between performance and asset flows indicates that investors should consider taking a closer look at emerging-market bonds, but — given the 10.7% total return for EMB since the beginning of June — some patience is called for here.

emb2 Emerging Market Bonds Are Hot ... Too Hot![5]

First, the good news: The strong 10-year results of emerging-market bonds are a direct result of the improving fundamentals of the asset class. Economic growth remains strong relative to the developed world, emerging economies are becoming more diverse (with an increased focus on services and consumer spending rather than commodity-related industries), and government finances are much healthier than they are in the developed markets. All of these factors have provided support for the emerging debt markets’ longer-term results, even as bouts of increased investor risk aversion have taken a toll on performance from time to time.

Short-term developments have been equally positive, with the coordinated jawboning[6] of the world’s central banks providing an across-the-board lift to higher-risk, higher-yielding assets.

All of this positive background has a flip side, however: The yields on emerging debt are now so low that investors should ask whether they’re being appropriately compensated for the risks.

The 30-day SEC yield on EMB has fallen to 3.66%, its lowest level since the ETF launched in late 2007. Moving into corporate bonds doesn’t provide much incremental yield given that the WisdomTree Emerging Markets Corporate Bond Fund (NASDAQ:EMCB[7]) yields just 4.06%. Even going far out on the risk spectrum won’t help much: The Market Vectors Emerging Markets High Yield Bond ETF (NYSE:HYEM[8]), which invests in the riskiest sovereign and corporate credits in the asset class, yields 5.77%. That might be attractive on an absolute basis, but HYG is paying essentially the same yield — 5.74% — with less risk.

Another way to look at this is by measuring yield in relation to volatility; in this case, measured by the three-year standard deviation figures provided by the iShares website. By this measure, emerging debt doesn’t stack up well versus other spread sectors on a risk-reward basis:

FUND TICKER 30-DAY YIELD 3-YR STANDARD DEVIATION RATIO
iShares JPMorgan USD Emerging Markets Bond EMB 3.66% 7.36% .497
iShares iBoxx $ High Yield Corporate Bond HYG 5.74% 8.71% .659
iShares iBoxx $ InvesTop Investment Grade Corp. Bond Fund LQD 3.02% 4.98% .606

This indicates that at current levels, emerging-market bonds are no longer offering much value. Even though the fundamentals of the asset class are robust and improving, it still remains vulnerable to risk-on/risk-off asset flows. At this level, it won’t take much of a downturn to erase EMB’s narrowing yield advantage over more diversified, lower-risk options.

As a result, investors might want to take a step back from emerging market bonds for now. While the performance has been outstanding in the past two months, the asset class remains vulnerable to any reversal in the current stampede into higher-risk assets.

If you don’t own emerging-market debt, consider it as a way to augment your portfolio’s income potential if a sell-off provides a better entry point. But at this level, it pays to be patient.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Endnotes:
  1. EMB: http://studio-5.financialcontent.com/investplace/quote?Symbol=EMB
  2. EEM: http://studio-5.financialcontent.com/investplace/quote?Symbol=EEM
  3. HYG: http://studio-5.financialcontent.com/investplace/quote?Symbol=HYG
  4. JNK: http://studio-5.financialcontent.com/investplace/quote?Symbol=JNK
  5. [Image]: http://investorplace.com/wp-content/uploads/2012/09/emb2.gif
  6. coordinated jawboning: http://investorplace.com/2012/09/the-global-currency-trade-is-heating-up-fxe/
  7. EMCB: http://studio-5.financialcontent.com/investplace/quote?Symbol=EMCB
  8. HYEM: http://studio-5.financialcontent.com/investplace/quote?Symbol=HYEM

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