Beat the Stock Market With Emerging Market Bonds

by Richard Band | November 17, 2011 7:00 am

Bonds Newspaper[1]

You can say one good thing about the August-to-September stock market swoon. It gave an investor committing new money the chance to earn higher future profits — lower prices going in means more upside potential. According to my proprietary stock-valuation model, which uses very conservative inputs for earnings growth and P/E ratios, it’s now reasonable to expect the S&P 500 index to generate a 7.3% compound annual return over the next 10 years.

That’s certainly a lot better than 2.2% on a 10-year Treasury note. A decade from now, if my projections pan out, $10,000 invested today in the S&P will grow to approximately $20,200. The same stake in a T-note, with reinvested interest, will increase to just $12,500.

But wait a minute — to earn those outsized returns, a stock investor must put up with huge monthly, weekly and even daily price swings. Isn’t there some way to beat the T-note without bungee-jumping your portfolio?

Yes, there is. In fact, the type of bond I’m going to tell you about has the potential to make almost as much money for you as the stock market in the coming decade, with roughly 30% less risk.

Emerging from Obscurity

I’m referring to emerging-markets bonds. In recent years, most U.S. investors have heard complimentary things about the developing stock markets of the world (especially Brazil, Russia, India and China — the so-called BRIC countries). The real unsung story, though, has to do with the emerging countries’ bond markets.

Only 13 years ago, in the fall of 1998, the developing world was a basket case. Russia had just defaulted on its debt and Indonesia, Korea and Thailand were facing currency and debt crises on much the same order as Greece today.

Through severe fiscal retrenchment, both the private and public sectors in most emerging countries healed their balance sheets. An economic boom followed, which continues, more or less unabated, to this day.

As a result, the developing countries now hold 60% of the world’s foreign-exchange reserves — no more currency-devaluation threat. Even more to the point, from a bond investor’s perspective, the typical government in the emerging markets carries less than half as much debt, relative to GDP, as the U.S. Investment-grade corporations domiciled in emerging markets are shouldering nearly 40% less debt, relative to equity, than their counterparts in developed economies.

In short, EM bonds generally are far less risky than they were a decade ago. Yet these bonds still command exceptionally high yields, in many cases approaching or even exceeding the total return I’m forecasting for the U.S. stock market over the next 10 years.

Diversify for Safety

For safety, I recommend buying a well-diversified fund of EM bonds, such as no-load TCW Emerging Markets Income N (MUTF:TGINX[2]). TGINX currently yields 7.3%.

That’s nifty enough, but get this: Over the past five years, the TCW fund’s share price has fluctuated, month to month, 34% less than the S&P 500 index.

I’m not saying TGINX is some kind of money market fund. The share price will bounce around, sometimes more than you might like — such as in September and October when investors around the globe worked themselves into frenzy over the woes of the European banking system.

Compared with a typical stock fund, however, TCW Emerging Markets Income is a model of stability. If you’re tired of the Dow’s extreme volatility, here’s an opportunity to take a break and still earn stock-like returns.

Closed-End Discount

My other route into EM bonds is through a closed-end fund, Western Asset Emerging Markets Debt Fund (NYSE:ESD[3]). As the name implies, closed-end funds don’t continuously issue and redeem shares. Instead, you generally have to purchase shares on the stock exchange from an existing owner. Likewise, to sell, you normally have to place an order with your broker, and the exchange matches you up with a buyer.

Because it’s set by supply and demand in the open market, the share price of a closed-end fund can drift away — sometimes far away — from net asset value (NAV — the value of the securities in the fund’s portfolio). I prefer to buy closed-ends when they’re trading at discounts to NAV. In effect, I’m buying $1 of assets for less than a buck, which increases my cash yield.

At last glance, ESD was quoted at a juicy 11% discount to NAV. Thus, you can buy $1 of emerging-markets bonds, professionally managed, for only 89 cents. Current yield: 7.2%.

With the discount, you might expect ESD to yield significantly more than the open-end TCW fund. Why doesn’t it? Approximately 60% of ESD’s portfolio consists of government bonds, while the TCW fund is only 20% in government paper.

In other words, ESD follows a more conservative investment strategy. Government bonds nearly always yield less than corporate bonds, so the discount, in ESD’s case, helps lift your yield on emerging-market government bonds to essentially the same level as corporate bonds. The extra safety comes free.

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  2. TGINX:
  3. ESD:

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