Emerging Market Bonds Are on a Roll. But How High Is the Risk?

 With low interest rates in the United States and Europe, emerging market bonds have excelled, income investors in the United States are waiting for a tailwind to kick in.

Source: The New York Times

It has been nearly two years since the Federal Reserve began to raise its core interest rate, yet income investors in the United States are still waiting for a tailwind to kick in.

Those who are willing to bear additional risk might turbocharge their returns with emerging market bond funds, an often ignored slice of the fixed income sector that lately has delivered a combination of high yield and high total returns.

The iShares J.P. Morgan USD Emerging Markets Bond, for example, pays a 4.5 percent yield and delivered a total return of more than 9 percent through the first nine months of the year. By comparison, the iShares Core U.S. Aggregate Bond E.T.F., an exchange-traded fund that invests in a broad slice of the investment-grade domestic bond market, pays a 2.5 percent yield and gained 3.1 percent in the same period.

Emerging market bonds denominated in local currency have had an especially good run recently as a slump this year in the dollar increased the purchasing power of other currencies. The Pimco Emerging Local Bond fund has a 5.2 percent yield and a total return of more than 14 percent through the end of September. (Total return is the combination of yield plus any change in the value of a portfolio’s bonds.)

Valuations are stretched after average gains of nearly 25 percent since early 2016, and rising rates in the United States would hurt bond prices. Yet many emerging market bond fund managers make a bullish case.

“For the first time since the financial crisis, we’ve got commodities stabilizing and a global growth story,” said Penelope Foley, a manager of TCW Emerging Markets Income fund. Emerging market companies are also reporting stronger earnings, which can make it easier to repay debt.

These fund managers do not expect the Fed’s actions to muck up the landscape.

“It depends why the Fed is tightening,” said Samy Muaddi, manager of T. Rowe Price Emerging Markets Corporate Bond fund. “If it’s because the U.S. is adding 200,000 jobs a month, that’s wonderful for emerging markets.” Economic growth that is strong enough for the Fed to try to pull rates a bit closer to normal should not be confused with rapid and steep rate increases meant to combat runaway inflation, he said.

The upshot is that even if rates rise in the United States, emerging markets can remain appealing as long as the global economic outlook remains positive because they offer higher yields.

Consider that investment-grade United States bonds with a five-year maturity currently yield 2.4 percent and that comparable eurozone bonds yield less than 1 percent. Yet similar-term bonds from India, Indonesia and Mexico have yields of at least 6.5 percent.

In a recent report, Brian Nick, chief investment strategist at TIAA Investments, wrote that over the past 20 years emerging market bonds had annualized gains of 6.9 percent when rates were rising in the United States, while an index of core American bonds lost 3.3 percent on average.

Tina Vandersteel, a leader of the asset management firm GMO’s emerging market debt team, said that after the recent strong run, her institutional clients said they would probably have to “rebalance away from us. But that hasn’t happened much.”

One reason is GMO’s track record. The GMO Emerging Country Debt IV fund’s 12.9 percent annualized gain over the past 15 years is three percentage points better than that of the average emerging market bond fund. Another reason is a lack of compelling alternative investments.

What may appeal to institutional clients requires careful consideration for 401(k) savers. The geopolitical risk that comes with investing in emerging markets means such fixed-income investments are not equivalent to those held in prudent, high-grade, core United States bond funds.

Beyond the risks within specific countries, China, a major trade partner for other emerging markets, casts a long shadow. If China has problems, other countries probably will, too.

“It’s a daisy chain in how these economies work,” said Kathy Jones, chief fixed income strategist at Charles Schwab. “China not being able to work its way out of its slowdown could have repercussions.”

If you have not paid attention to emerging markets for a long while — since the Latin American debt crisis of the 1980s, for example, or the Asian financial crisis of the 1990s — it is worth noting that many countries have far more stable economic and monetary policies today.

Many nations now allow their currencies to float, rather than be artificially fixed. They hold much more foreign currency, which may help the next time foreign investors rush for the exits. And their central banks have a stronger hand on the rudder.

Michael Hasenstab, chief investment officer of the Templeton Global Macro group at Franklin Templeton Investments, said in an email that these improvements “were tested and affirmed by impressive resilience during the global financial crisis, with many emerging markets able to avoid recession.”

The Templeton Global Bond fund can invest anywhere, and about $25 billion of the nearly $40 billion fund is invested in emerging market bonds. Securities from Brazil, Colombia, India, Indonesia and Mexico are the biggest stakes.

Countries that relied on external trade and investor demand a few decades ago now have growing, consumer-driven, domestic markets and increasing local investment, along with revised economic and monetary policies.

“The label ‘emerging markets’ is almost unfortunate,” Mr. Muaddi of T. Rowe Price said. “It’s a label from 25 years ago when emerging markets were 15 countries.”

Today, he said, there are 70 emerging market countries, including established ones and their outlier cousins in so-called frontier markets, and all of them have their own idiosyncratic characteristics. “Tajikistan is not Indonesia,” Mr. Muaddi said.

About two-thirds of emerging country debt is now rated as investment grade. It is a mix of government bonds, corporate bonds and a combination called quasi-sovereign, which is debt from companies that are state owned. One quasi-sovereign bond issuer popular with emerging market funds is Petróleos Mexicanos, the state-owned Mexican energy company known as Pemex.

Emerging market debt can be issued in local currency, or in a hard “external” currency. That is probably code for dollars, although some emerging market debt is tied to euros or Japanese yen. Even with the recent slide in the dollar, Ms. Vandersteel of GMO said, “local currencies are still cheap.”

But predicting currency trends is one of the riskiest aspects of emerging market investing. And when the dollar rises, local-currency bonds tend to suffer. From 2013 through the end of 2015, the dollar gained 25 percent against a basket of currencies, and the average emerging market local currency bond fund lost 23 percent, according to Morningstar.

“If you are going to invest in emerging market bonds you have to ask yourself what risks are you willing to take,” Ms. Jones of Charles Schwab said. The iShares J.P. Morgan USD Emerging Markets Bond E.T.F., the largest in its category, tracks an index of United States dollar bonds, eliminating currency risk. VanEck Vectors J.P. Morgan EM Local Currency Bond, on the other had, follows an index of local-currency bonds.

Something else to keep in mind is that emerging market bond indexes often track a small fraction of a targeted market. Old-school active fund management can earn its keep in these sectors. The Fidelity New Markets Income FundT. Rowe Price Emerging Markets Bond Fund and TCW Emerging Markets Income Fund hunt among the entire emerging market bond universe, and have the flexibility to mix dollar and local-currency bonds. The annualized returns for all three funds over the past five years is more than a half a percentage point better than the return for the iShares J.P. Morgan USD Emerging Markets Bond E.T.F.

Ms. Jones recommended that investors limit all noncore bond investments to around 10 percent of their fixed-income portfolio.

“Risks exist,” she said, warning that volatility in emerging market bonds could be severe. “This is not a short-term trade at this level,” she said. You need an investment horizon of at least five years.”