This is part two of a three-part series investigating whether Emerging Market bonds can enhance passive portfolios. Today we’ll consider Emerging Market bond risks.
But very few cases are one-sided in investing.
A big question mark still hangs over EM US$ sovereign debt.
Specifically, is its superior historic performance dependent on tailwinds that have mostly died down?
Emerging Market bond risks
The rise of Emerging Market bonds is partly a phoenix-from-the-flames success story.
Burned by crisis in the ’90s, developing world economies reformed their financial institutions. Their governments controlled spending and improved debt-to-GDP ratios. There was the helpful growth of China and globalisation, too.
Credit rating upgrades followed. Investors enjoyed high yields buoyed by outdated perceptions of Emerging Market bond risks.
Demand for EM debt got a further boost as Developed World yields shrunk. Many investors hunted further afield for income like truffle-loving pigs in a forest.
Fast-forward to 2021 and:
Globalisation has stalled
Emerging Market bond yields have declined and credit spreads tightened.
Vanguard warns EM bond outperformance could be a historical artifact:
A number of trends – including falling interest rates, tightening spreads, and several equity bear markets – substantially explain what we expect was a historical anomaly.
Over longer periods, we believe investors can reasonably expect to be compensated for equity risk through realization of the equity risk premium.
Source: Vanguard. (“Emerging-market bonds: a fixed income asset with equity-like returns (and risks).” August 2018. Page 7.)
To put that quote in context, Vanguard’s researchers cautioned against expecting Emerging Market bonds to continue to beat Emerging Markets equities on an absolute return basis.
Reading between the lines
Indeed any bond-curious metric we check doesn’t augur well for a repeat of EM bonds’ Olympian performance of the past 20 years.
Yields have waned on Emerging Market bonds to near historic lows:
Yield-to-maturity (YTM) peaked at 15.6% in August 1998 as financial shocks ripped through Emerging Markets. The YTM is now below 5%.2
In other words, we’re being offered less reward for taking risk today than the bond investors of yesteryear.
Note, the bulk of long-term bond returns turn on the size of their coupons.3 This is especially true at the intermediate durations that dominate EM US$ sovereigns. Today’s lower bond interest payments signal moderate rewards ahead.
Similarly, credit spreads (vs US Treasuries) have tightened:
The credit spread peaked at 1321 basis points – that’s 13.2% – in August 1998. The historic low was 1.6% in May 2007, just before the Great Recession convulsed the world. This spread is 3.3% at the time of writing.4
The mountainous credit spreads and yields of the late ’90s and early ’00s indicate EM debt was consigned to basket-case status back then.
A fear of further defaults jacked up yields.
But Emerging Markets comfortably surpassed investor’s low expectations in subsequent years.
Which meant those elevated yields rewarded investors who took on risks that happily failed to materialise.
The subsiding credit spread indicates the perceived risk of default is lower today.
Comforting. But it also implies there’s less room for ‘equity-like’ upside.
Ultimately defaults will probably rise and fall in line with the global boom-bust cycle. An investor in Emerging Market bonds will lose when yields lag defaults. They’ll win when the market over-reacts and higher yields dominate even as defaults hold steady or decline.
As a passive investor I can no more time this default cycle in bonds than I can exploit stock market turbulence.
EM bond durations have also increased a touch over time. We’re taking on more ‘term risk’ today to bag our yield.
Finally, the EM debt market is much bigger than it was. It’s not a secret anymore.
So much for history’s rear-view mirror. How about forward expectations?
Fund manager Research Affiliates provides a brilliant range of tools, including expected return forecasts.
And these are pretty downbeat for Emerging Markets US$ sovereign bonds over the next ten years:
This expected returns chart shows annual GBP real returns (based on current valuations) of:
0.7% Emerging Markets US$ sovereign bonds (blue bar)
5.1% Emerging Market equities (red bar)
Note: Research Affiliates offers a range of returns along a probability distribution curve. I’ve stated the mean return.
Research Affiliates also offers an alternative forecast model that shows Emerging Market bonds in a better light. This uses yield and growth predictions instead of current valuations:
2.8% Emerging Markets US$ sovereign bonds (blue bar)
4.8% Emerging Market equities (red bar)
I don’t have an opinion about the efficacy of these different models. You can find Research Affiliate’s methodology on its website if you’d like to delve.
Will Emerging Market bonds yield for you?
One gauge of a bond fund’s annual expected return is its current yield-to-maturity.
Current yield-to-maturity is a reasonable estimate of what you can expect to earn over the fund’s duration.
The following chart shows that current YTM is quite well-correlated to actual returns for EM US$ sovereigns:
A quick eyeball of accessible EM US$ sovereign bond funds gives us a starting yield of around 4%. The average duration is about 8.
That’s more encouraging. Although the one thing we can be sure of with any long-range forecast is that it will be wrong!
What should we do?
I don’t think anyone should oust Emerging Market equities from their portfolio expecting Emerging Market bonds to score higher returns.
That’s because it’s reasonable to assume the equity risk premium will reassert itself sooner or later.
Rather, the case turns on the chance of EM US$ sovereigns continuing to deliver superior risk-adjusted returns versus EM equities.
Any retreat from globalisation or a misfire from China’s growth engine will hurt EM equities. And rising EM bond defaults will probably correlate with such stock market drama.
The fates of the two sub-asset classes are therefore intertwined.
That said, Emerging Market governments can raise taxes, dip into currency reserves, and raise loans from the IMF and World Bank. That makes them less risky than EM equities, in my view.
Moreover, Monevator’s friendly quant, ZXSpectrum48k, has argued:
I also like the absence of EM FX exposure which I think you are simply not compensated for in EM equities. EM sovereign debt has produced the same returns as EM equities but with a fraction of the volatility. It also offers a somewhat lower correlation with broader equities.
UK investors are exposed to US$ currency risk via Emerging Markets US$ sovereign bonds, but not to Emerging Market currency risk.
There’s no need to hedge this US$ risk, as Emerging Market bonds should be allocated to the equity side of your portfolio. And currency risk can be seen as a diversifier, as long as it isn’t in your defensive asset allocation.
Speaking of diversification, the geographic spread of Emerging Markets US$ sovereign bonds is quite different to Emerging Markets equity.
Take a look at the Regional Split rows below:
State Street. “Case for Allocating to Emerging Market Debt.” February 2021. Page 6.
Latin America, Central and Eastern Europe, and the Middle East and Africa are much better represented in EM US$ sovereigns.
In contrast, the Asia Pacific region dominates Emerging Market equities.
(Note: Emerging Market US$ sovereign bonds are labelled Hard Currency Sovereign EM Debt at the top of the left-hand column.)
You can also see that EM US$ sovereigns have decent yield, intermediate average duration, and a credit risk exposure that’s split across investment grade and sub-investment grade (junk) bonds.
Final asset allocation thoughts
Monevator contributor and former hedge fund manager Lars Kroijer made the case for diversifying into riskier EM government debt in his book Investing Demystified.
Lars suggested a 10% allocation to sub-AA government debt carved out of the equity side. He calculated this was roughly in line with the global split of risky assets between equities, corporate debt, and sub-AA goverment debt. (At the time he was writing).
Lars didn’t argue that Emerging Market bonds were vital or transformative.
Rather Lars was showing how to enhance diversification if you can live with the complexity.
Emerging Market bond risks may be worth taking for diversification
Personally, I haven’t yet been rewarded for increasing complexity in my own portfolio.
Despite this, I do still look for opportunities to diversify. The future often throws up surprises that backtests and forecasts gull us into believing we can factor out.
I have no actionable view on the future direction of US interest rates, the China-America trade relationship, or the fiscal positions of 74 Emerging Market countries.
Nonetheless I’m likely to soon split my EM equity allocation in half. This will enable me to allocate 5% to Emerging Markets US$ sovereign bonds.
Such a small allocation is unlikely to make a big difference one way or the other. But I think it’s appropriate to the merits of the case.
In part three I’ll look at the best Emerging Markets US$ sovereign bonds index trackers we can buy.
(Right after I’ve pulled these fence splinters out of my backside!)
Take it steady,
P.S. Bond fund taxation is typically higher than with equities. This could be another black mark against Emerging Market bonds if you can’t fit them into your tax shelters.
See Vanguard. “Emerging-market bonds: a fixed income asset with equity-like returns (and risks).” August 2018. Page 7.
That’s according to the market-dominant JPM EMBIGD index of EM US$ sovereign bonds.
How much a bond pays in regular interest payments.
Again, according to the market-leading JPM EMBIGD index of EM US$ sovereign bonds.