Why you might want to add emerging market debt to your portfolio
David Stevenson explores why, in our world of quantitative easing and negative yields, investors looking for positive yields should look at emerging market debt.
We live in the age of quantitative easing and massive monetary stimulus. As central banks snap up ever more bonds using printed money, the prices of bonds have risen steadily. This in turn has the effect of pushing yields (interest paid) ever lower.
As a result, as we discussed in last week’s email, many super-safe government securities now yield less than zero – ie, they’re in negative territory.
This means that an investor will receive less at maturity than they invested up front (assuming they buy and hold until maturity, of course).
So where can investors go for a positive yield?
Why investors are increasingly interested in emerging market debt
The following story sums up the dilemma of today’s bond investors nicely. Just a couple of months ago, Belgium managed to sell €1.519bn of an 0.10% 2030 bond (ie, a bond with ten-year maturity) at a weighted average yield of -0.229%.
That’s just the tip of the iceberg – many trillions of dollars worth of bonds currently offer a negative yield. Given these circumstances, it’s no surprise that investors have grown increasingly interested in emerging market (EM) debt. Yields from a variety of EM issuers at both the governmental and corporate level can be extremely attractive.
According to a recent study from Nicolas Rabener at research group FactorResearch, over the 12 months to July 2020, EM debt in its various guises (dollar government debt, local currency government debt and corporate bonds in dollars) yielded an average of between 4.4% and 4.7%. By contrast, US government bonds yielded just 1.7%, and US corporate bonds an average of 3.1%. Only US high-yield bonds (those deemed high risk) yielded more, on an average 5.4%.
EM debt comes in three broad varieties. The biggest and most established segment is EM government debt denominated in dollars. This has proved popular for one very obvious reason – the currency risk is lower, as the bond is denominated in US dollars. By contrast, many emerging markets boast volatile currencies, which crash (devalue) with alarming regularity. Buying into dollar-denominated bonds eliminates that risk.
The next biggest category tends to be EM government debt denominated in local currencies. Investor interest in this category has risen sharply in recent years as yields are often higher, in part because investors demand to be compensated for the aforementioned currency risk.
The final broad category is EM corporate debt, which is usually denominated in dollars. This type of debt tends to offer higher yields than EM government dollar debt, largely because of default risk – in other words, the danger that the company issuing the debt goes bust.
Large corporations in countries as diverse as Turkey, South Africa and Malaysia can and do default on their debts, although arguably not quite as regularly as many investors would imagine. And to be fair, EM governments can also default on their debts – look no further than Argentina in 2014 or Lebanon in 2020.
Emerging market debt can be a useful portfolio diversifier
Beyond the attractive yields, dollar-denominated EM corporate debt has offered another useful feature. Intriguingly, the asset class has a relatively low correlation with developed-world – and specifically US – equities, except during global crises such as the Covid-19 outbreak. Thus, an investor with a diversified portfolio of both stocks and bonds may find that EM corporate debt adds a useful source of risk diversification.
On the topic of returns and risk, it’s also worth noting that EM debt over the last decade has offered superior returns to EM equities – according to further analysis by FactorResearch, EM stocks generated a compound annual return of -1.3% from 2011 to 2020, whereas EM bonds generated positive annual returns.
However, stepping back from the different flavours of emerging-market risk, it’s worth making one last crucial point – in times of crisis, all forms of emerging market exposure (bonds and equities) tend to be vulnerable. Put simply, when there’s any sort of financial panic, as in 2008 or in the 2020 Covid-19 crisis, investors in the developed world will flee from risk. That means they want to invest their money in so-called “safe haven” assets, usually based in the US and priced in US dollars.
Emerging-market equities and debt are viewed as risky. That’s why they tend to offer higher returns, but it’s also the reason they are frequently among the first assets to sell off as investors panic, with the proceeds reinvested into either US Treasury bonds or cash.
However, having said that, it is also important to point out that not all EM bonds are created equal. The numbers cited earlier refer to a broad global category of EM bonds, government or corporate.
Individual countries, by contrast, can produce widely varying returns, and also will prove more or less resilient, depending on factors including governance and track record. This offers the active manager in emerging markets the opportunity to create superior returns by careful country selection.