Why We Like Emerging Markets Bonds

When we initiated positions in emerging sovereign bond markets in late 2008, we were relatively early in embracing the asset class as a core holding within portfolios. At the time, many investors saw emerging markets debt, or EMD, as a niche asset class. Yet our research indicated that it had changed dramatically over the previous decade. More emerging countries were allowing their currencies to trade freely in the market rather than pegging them to the US dollar. Their economies had become more competitive, corporate governance had improved, and emerging nations were generally more politically and socially stable than they had been a decade earlier. Importantly, many had successfully addressed longstanding structural issues over the previous decade. Public (i.e. government) balance sheets had improved dramatically. In many instances, government budget deficits and government debt as a percentage of GDP were now smaller than in many developed nations. Not only that, but emerging economies held greater growth potential than developed economies, making it very likely that growth in public revenue would rather easily cover their governments’ fiscal obligations. In short, we were able to buy debt supported by strong balance sheets with very attractive yields.
 

Emerging sovereign debt markets performed exceptionally well over the following four years with the exception of a modest loss in local currency denominated bonds in 2011. From 2009 through 2012, emerging sovereign bond markets posted double-digit annualized returns. Emerging markets bonds denominated in the currencies of their issuers, as measured by the JP Morgan GBI-EM Global Diversified Index, provided equity-like returns with significantly less volatility while those denominated in US Dollars, as measured by the JP Morgan EMBI Global Diversified Index, fared better yet, producing better returns than US and developed equity markets while incurring dramatically lower volatility (Dollar-denominated debt is typically less volatile than its local currency-denominated counterpart because it lacks the volatility associated with currency fluctuations) (Table 1). The strong returns coupled with lower volatility resulted in better risk-adjusted performance as measured by the Sharpe Ratio. Why is volatility important? From a mathematical standpoint, lower volatility means more efficient compounding of returns. If, on average, two investments have the same expected return, lower volatility yields a higher compound rate of return (Table 2). While mathematics supports the case for a lower volatility portfolio for a given return expectation, the proposition is also emotionally appealing. Surely it’s easier to sleep at night with the first portfolio than with the second or third. And you get paid more to rest easy.

Table 1: Performance 2009 - 2012	Annualized Return	Standard Deviation	Sharpe Ratio
EMBI Global Div Index	16.42	6.67	2.45
GBI-EM Global Div Index	12.80	12.96	0.98
MSCI EAFE	10.51	21.02	0.49
MSCI Emerging Mkt	19.97	24.22	0.82
S&P 500	14.58	16.96	0.85

Table 2	Year 1	Year 2	Year 3	Simple Average	Annualized Average
Portfolio 1	8%	8%	8%	8%	8.00%
Portfolio 2	8%	-8%	24%	8%	7.20%
Portfolio3	8%	-16%	36%	9.33%	7.25%

Of course, this year has been a very different story as both stocks and bonds in emerging countries have declined significantly. Investors have been concerned that the European recession, weak growth in the US, and increased competition from Japan due to the rapid devaluation of the Yen will crimp growth prospects for emerging economies. However, we believe that the real driver behind this year’s performance in emerging stock and bond markets has been concern that the Fed may reduce, or even end, its quantitative easing program (i.e. bond buying program), resulting in the reversal of carry trades. Carry trades involve borrowing in a currency where interest rates are exceptionally low to take advantage of higher yielding investments denominated in another currency. Also, US dollar-denominated emerging debt trades at a spread (i.e. yield premium) to US Treasuries. As the concerns over the Fed’s purchase program have pushed up Treasury yields, yields on emerging US Dollar-denominated debt have also risen. Finally, global bond markets have less liquidity than they did prior to the credit crisis due to legislation that had altered the willingness of financial institutions to make markets in, and hold inventory of, bonds across many asset classes. The result has been somewhat of a perfect storm for emerging bond markets. The local currency denominated benchmark, the JP Morgan GBI-EM Global Diversified Bond Index, is down 11.45% year-to-date while the US Dollar-denominated benchmark, the JP Morgan EMBI Global Diversified Bond Index, is down 9.03% year-to-date through August. The loss in the former is largely due to currency depreciation against the US Dollar with the benchmark down a far more modest 2.84% when measured in local currency. The loss in the US Dollar denominated benchmark is due to rising Treasury yields and the widening of spreads between US Treasuries and emerging government bonds. As a result of these price declines, yields on both benchmarks have risen to rather attractive levels for fixed income securities rated, on average, at the low end of the investment grade spectrum (for the local currency benchmark) and at the highest end of the high yield spectrum (for the dollar-denominated index). The benchmarks yield multiple percentage points more than the 10-year debt issued by similarly rated nations from the troubled European periphery. Note that while the table below compares the yields on the benchmark to the yields on benchmark 10-year bonds of the European periphery, the average maturity of the two emerging markets benchmarks are less than 10-years (Table 3).

Table 3	S&P Ratings	S&P Ratings
	Local Currency	Foreign Currency	Yield
Italy	BBB	BBB	4.51%
Spain	BBB-	BBB-	4.53%
Ireland	BBB+	BBB+	4.02%
Portugal	BB	BB	6.96%
Greece	B-	B-	10.46%
EMBI Global Div Index	NA	BB+	6.27%
GBI-EM Global Div Index	BBB+	NA	6.99%

As an asset class, the bonds of emerging sovereign governments offer investors an opportunity to earn far higher yields lending to countries with stronger growth prospects, and in many instances, stronger balance sheets, than they can lending to overly indebted developed countries with poor growth prospects. Global bond markets are likely to remain volatile as investors parse every word from the Fed and assess what any policy changes may mean for global markets. Emerging debt markets are likely to remain volatile as the markets continue to evaluate potential and actual changes in Federal Reserve Policy and the volatility may be exacerbated by a the lower liquidity that has pervaded bond markets due to US legislative changes. Yet the current weakness offers an opportunity for investors to purchase assets with sound fundamentals and attractive yields at discounted prices. Moreover, the recent gulf in performance between emerging bond markets and developed equity markets suggests that their return potential over the subsequent three to five years is likely similar to, or better than, US and developed international equity markets. Coupled with the lower long-term volatility profile of emerging bond markets relative equities, the asset class offers not only attractive absolute returns, but very attractive risk-adjusted returns over the long-term.