Emerging-Market Bonds Are Looking Riskier By the Day

by Daniel Putnam | May 17, 2013 6:15 am

Anyone who has been invested in emerging debt in recent years has enjoyed outstanding returns. In the 10 years through April 30, the JP Morgan EMI Global Diversified Index generated an average annual total return of 9.96%. That’s better than the Barclays US Government Long Index (7.53%) the Credit Suisse High Yield Index (9.48%), the S&P 500 (7.88%) and the MSCI EAFE (9.23%).

At this point, however, investors need to be cautious.

Index-linked products that focus on government bonds are certainly offering more yield than can be found in the average domestic bond fund, but the absolute yield levels are unattractive relative to the potential risks. For example, the iShares JP Morgan USD Emerging Markets Bond Fund (EMB[1]) has an SEC yield[2] of just 3.58%, while the PowerShares Emerging Markets Sovereign Debt Portfolio ETF (PCY[3]) yields 3.77% — well below the levels of just three years ago.

It makes sense that emerging-market funds offer yields beneath their own historical levels thanks to their improved credit ratings and the ultra-low rates available in other segments of the bond market. Still, this doesn’t mean investors are being appropriately compensated for the risks.

First, even though the emerging debt markets are much stronger and deeper than they were in the past, they still are vulnerable on the occasions when investors go into “risk-off” mode. The last two times this occurred, EMB was hit hard. The ETF fell 6.9% in less than a month in autumn 2011, and it declined 4.9% from May 3-June 1, 2012. With yields so low, there is little “cushion” in the event that risk assets once again turn south.

Emerging-market government debt is also less attractive right now since the cycle of interest rate cuts in the developing world has largely run its course. In fact, the general trend could begin to move toward rate increases in the emerging markets before the year is out. This removes an important tailwind that has been in place for nearly five years.

Emerging Corporates Aren’t Necessarily the Answer

Given the low yields on government debt, more investors are moving into emerging market corporates via funds such as WisdomTree Emerging Markets Corporate Bond Fund (EMCB[4]), which has gained 12.2% since its inception in March 2012. At this point, however, the yields just aren’t there. EMCB has an SEC yield of 3.67%, while iShares Emerging Markets Corporate Bond Fund (CEMB[5]) and SPDR BofA Merrill Lynch Emerging Markets Corporate Bond ETF (EMCD[6]) are yielding 3.26% and 3.47%, respectively.

While these yields place the three funds well above average for the bond ETF universe, they aren’t paying investors for the associated risks. Notably, they offer very little spread vs. the iShares Investment Grade Corporate Bond Fund (LQD[7]), which is yielding 2.77%. It’s true that investment-grade corporate issuers in the developing world, as a group, have strong balance sheets, with many only having accessed the capital markets to create a history of borrowing and repayment. Still, emerging corporates are priced for perfection — a potentially dangerous proposition for one of the riskiest areas of the fixed income universe.

Be Patient With Emerging High Yield

Even riskier are the two options investors now have to access emerging-market high-yield bonds: Market Vectors Emerging Markets High-Yield ETF (HYEM[8]) and iShares Emerging Markets High Yield Bond Fund (EMHY[9]). Both funds yield 5.63%, which ties them for the second on the list of highest-yielding bond ETFs, as compiled here[10].

Looking out 10 years, these two funds will probably provide more capital appreciation than the vast majority of options within the bond fund universe. In addition, they are among the least vulnerable to the impact of rising rates in the United States — which is sure to be an important consideration within the next three years.

But in the near-term, these products are vulnerable to the possibility that the rally in emerging-market sovereign debt has largely run its course. Investors who are reaching too far out the risk spectrum in search of yield might be surprised at just how much downside potential accompanies the 5.6% yields in the event that the markets go “risk-off.” This is particularly true given that the funds — as well as the asset class itself — have such a short track record.

Income investors should keep these funds on their watch list, but it’s wise to wait for the financial markets to become a little less frothy before establishing a position.

Local Currency Bonds Offer a Slightly Better Profile

Local-currency funds are rapidly growing into a distinct asset class thanks to the creation of five ETFs and countless mutual funds devoted to the space. The highest-yielding fund in the space is Market Vectors Emerging Markets Local Currency Bond ETF (EMLC[11]), at 4.47%, while the largest is WisdomTree Emerging Markets Local Debt Fund (ELD[12]), at just over $2 billion in assets.

Local currency bonds offer an interesting longer-term opportunity for three reasons: They offer higher yields, they can deliver better performance better when rates are rising (since rate increases are a positive for currency performance), and they provide investors with a way to diversify out of U.S. dollars and gain access to currencies with better long-term appreciation potential.

Investors are considering emerging debt for a long-term investment will therefore want to take a good look at this space. Still, even though this segment has the potential to outperform dollar-denominated debt, it will also track funds such as EMB and PCY on the downside if emerging market bonds do indeed begin to weaken. As is the case with high yield, there’s no rush to invest.

Active Management Can Add Value Here

One takeaway from the discussion above is that “emerging-market bonds” is no longer a monolithic asset class dominated by dollar-denominated government debt. At a time in which emerging-market debt is vulnerable to subpar returns, this might be a time when investors are better off looking at an actively managed[13] mutual fund rather than an ETF focused on one specific area of the market.

Morningstar’s sortable list of emerging-market bond funds is available here[14] without a subscription. The top fund for the five-year period is TCW Emerging Markets Income I (TGEIX[15]), which has delivered a five-year average annual return of 13.79% and outpaced the 8.91% category average.

While it isn’t advisable to pick a fund based solely on its past performance, the TCW fund — which yielded 5.59% as of March 31 — has a “go anywhere” strategy that allows it to invest in corporates or sovereigns, and both dollar-based debt and local currencies. At this stage of the rally in emerging-market bonds, this type of flexibility is attractive relative to an index-based approach.

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

Bottom Line

Emerging debt has delivered stellar past performance, and the potential long-term return potential of certain segments is very attractive. This kind of potential is especially compelling at a time in which funds tied to the Barclays Aggregate are only yielding 1.5% to 1.6% — barely enough to stay ahead of inflation.

Right now, however, the near-term outlook for emerging isn’t particularly attractive with sovereign yields where they are. Exercise patience if you’re thinking of investing in emerging market bonds.

  1. EMB: http://studio-5.financialcontent.com/investplace/quote?Symbol=EMB
  2. SEC yield: https://investorplace.com/2012/07/etf-yields-arent-a-clear-cut-number/
  3. PCY: http://studio-5.financialcontent.com/investplace/quote?Symbol=PCY
  4. EMCB: http://studio-5.financialcontent.com/investplace/quote?Symbol=EMCB
  5. CEMB: http://studio-5.financialcontent.com/investplace/quote?Symbol=CEMB
  6. EMCD: http://studio-5.financialcontent.com/investplace/quote?Symbol=EMCD
  7. LQD: http://studio-5.financialcontent.com/investplace/quote?Symbol=LQD
  8. HYEM: http://studio-5.financialcontent.com/investplace/quote?Symbol=HYEM
  9. EMHY: http://studio-5.financialcontent.com/investplace/quote?Symbol=EMHY
  10. here: http://bonds.about.com/b/2013/05/15/the-highest-yielding-bond-etfs.htm
  11. EMLC: http://studio-5.financialcontent.com/investplace/quote?Symbol=EMLC
  12. ELD: http://studio-5.financialcontent.com/investplace/quote?Symbol=ELD
  13. actively managed: https://investorplace.com/2013/02/for-bonds-investors-its-time-to-get-active/
  14. here: http://news.morningstar.com/fund-category-returns/emerging-markets-bond/%24FOCA%24EB.aspx
  15. TGEIX: http://studio-5.financialcontent.com/investplace/quote?Symbol=TGEIX

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