- Bonds of emerging countries and corporations pay well, but they also carry a lot of risk.
- Analysts and economists expect long-term rates in the U.S. to trade within a range as inflation remains muted and the domestic economic expansion approaches its 10th year — possibly driving a search for yield in emerging markets.
- Some advisors, however, remain unconvinced and choose to take risks only in stocks, using low-risk, high-quality bond investments to balance a portfolio.
There is one good reason to buy the bonds of emerging market countries and corporations. They pay well.
In an environment where the 10-year U.S. Treasury bond yield is struggling to hold 3 percent and the average return on long-term investment grade corporate bonds is barely above 4 percent, the more than 6 percent average yield on emerging market debt is an attractive proposition.
Last year the JPMorgan Global Emerging Market Bond index had a total return of 9.1 percent.
"We believe U.S. investors should have an allocation to emerging market bonds," said Pablo Goldberg, a senior fixed-income strategist for BlackRock, which manages more than $24 billion in assets in a variety of emerging market bond funds. "They have a higher yield, they have good fundamentals, commodities prices are firm, and investors can diversify their currency risk."
There is one good reason not to buy EM bonds, however: They carry a lot of risk.
In the bipolar investment markets post-financial crisis, emerging market assets — both stocks and bonds — have always been among the first assets to suffer when things get volatile. Witness the sharp drop in EM asset values after the so-called Taper Tantrum in 2013, when the Federal Reserve said it would scale back its bond-buying program. The sector experienced a two-year hangover.
With the return of volatility in domestic markets, the question now for yield-seekers in emerging markets is whether this time around things will be different.
George Rusnak thinks so.
"The emerging markets are more robust now," said Rusnak, co-head of fixed-income strategy for the Wells Fargo Investment Institute. "More countries and companies issue debt in their own currency, and they have better access to markets across the liquidity curve.
"It makes them better able to withstand challenging times," he added.
These are challenging times. With interest rates in the United States rising, emerging market debt becomes relatively less valuable and prone to flights of capital if a risk off mentality rears its ugly head again. Emerging market currencies have also been falling relative to the U.S. dollar of late. Already, the sector (as represented by the iShares JPMorgan USD Emerging Markets Bond ETF) is down more than 5 percent for the year through May 16. If the 10-year Treasury bond yield continues to rise through the 3 percent level, it will get worse for emerging markets — particularly for local currency denominated funds that suffer from a stronger U.S. dollar.
This time, however, it could be different. For one thing, most analysts and economists expect long-term rates in the United States to trade within a range as inflation remains muted and the domestic economic expansion approaches its 10th year.
"The 3 percent level is still quite low, and we don't think it will decrease the search for yield," said BlackRock's Goldberg. "What could hurt emerging markets, however, is if rates start rising rapidly."
Fundamentally, the investment thesis for emerging market debt looks much better than it has in even the recent past. The global economy is finally starting to hum, and export-driven emerging markets will benefit. The World Bank is estimating the global economy will grow at a 3.1 percent rate this year, with growth of 4.5 percent for emerging markets and 4.7 percent in 2019.
EM countries have also generally gotten their financial houses in much better order. Other than a couple of outliers, such as Turkey and Greece, the debt/GDP ratios of EM sovereigns have remained stable at between 40 percent and 50 percent — less than half the ratios in developed market countries. China is the notable exception, with sovereign debt exceeding 200 percent of GDP.
More EMs are also now letting their currencies float against other currencies, eliminating the risk of devaluation shocks, and their central banks have adopted inflation fighting monetary policies that should make for more stable capital markets.
Add in the recovery of commodity prices, which many EMs are levered to, and the economic picture looks very good. Rusnak at Wells Fargo currently favors emerging market bonds over domestic high yield because of the fundamentally stronger outlook, and because they have not had as strong a run as junk bonds. He has a preference for sovereign bonds over the more highly leveraged corporate sector and favors credits in Europe, the Middle East and Asia over Latin America.
"There is risk, and that's why investors are compensated with a higher reward," said Rusnak, who recommends investors use actively managed funds in the sector to avoid country specific risks. "It's a question of where you want to take your risks." He has a neutral weight position in emerging market debt and is underweight developed market debt.
Brian Haywood, an investment strategy advisor for BAM Advisor Services, doesn't think it's worth taking risks in either emerging markets or junk bonds.
"We don't buy any emerging market or high-yield debt for clients," said Haywood. "We buy fixed income investments to help dampen volatility when equities hit the skids.
"Emerging market debt and junk bonds have a high correlation with equities, so they're not a good diversifier."
Haywood said he can replicate the risk profile of a portfolio of equities and emerging market/junk debt by simply adjusting the proportions in an equities/Treasurys mix.
He is not alone. Many financial advisors choose to take their risks only in the stock market and use low-risk, high-quality bond investments to balance a portfolio. "I'll never say never but I don't see us buying emerging market or high-yield debt anytime soon," said Haywood.
Until the emerging markets can prove they are not at the bottom of the pecking order when global investors hit the panic button, it's likely that many investors will also remain cautious.
— By Andrew Osterland, special to CNBC.com