Emerging market bonds are the bonds issued by the governments or corporations of the world’s developing nations. Emerging market bonds are seen as being higher risk, since smaller countries have been perceived as more likely to experience sharp economic swings, political upheaval, and other disruptions not typically found in countries with more established financial markets. Since investors need to be compensated for these added risks, emerging countries have to offer higher yields than the more established nations.
Risk and Return – What to Expect from Emerging Market Bonds
Like high yield bonds, emerging market debt is an asset category for investors who are willing to stomach above-average credit risk in the quest for higher longer-term returns. Through July 31 2012, the J.P. Morgan EMI Global Diversified Index – a benchmark commonly used to measure the performance of emerging market bonds – produced an average annualized return of 11.89% over the previous ten years. The average emerging market debt fund returned 12.54% annually during the same period. Naturally – as the fund companies’ legal disclaimer goes – past performance is no guarantee of future results.
In comparison, the Barclays Aggregate U.S. Bond Index – which measures the investment-grade segment of the U.S. market – returned 5.65% in the same period. The large advantage for emerging market bonds is due in large part to their higher yields. However, it’s also important to remember that they did it with more volatility (i.e., a bumpier ride) than most other options in the fixed-income universe. This may not be a top consideration of a longer-term investor, but someone who isn’t inclined to withstand higher volatility may have been better off taking a more conservative approach.
On the spectrum of risk and reward, emerging market bonds fall in between investment-grade corporate bonds, which tend to be relatively stable but are more risky than U.S. Treasuries or municipal bonds, and high-yield bonds. Emerging market debt should therefore be considered a longer-term investment that isn’t suitable for someone whose top priority is the preservation of capital.
Reasons for the Strong Performance of Emerging Market Bonds
Emerging market bonds have evolved from a being an extremely volatile asset class in the early 1990s to a large, more mature segment of the global financial markets today. Emerging nations have gradually improved in terms of political stability, the financial strength of the issuing countries, and the soundness of government fiscal policies. While a number developed nations struggle with budget deficits and high debt, many developing countries feature sound finances and more manageable levels of debt. Additionally, the developing countries – as a group – enjoy stronger rates of economic growth than their developed-market peers.
The result has been lower yields compared with the 1990s, but also greater price stability. Nevertheless, emerging market bonds remain vulnerable to external shocks that weaken investors’ appetite for risk. The asset class therefore remains volatile despite the fundamental improvements in the economies of the underlying nations.
Emerging Market Bonds’ Role in Portfolio Diversification
Emerging market bonds can provide diversification for those with bond portfolios that have more of a U.S.-centric focus. Emerging economies don’t always move in tandem with the developed economies, which means that the bond markets of the two groups can also provide divergent performance.
Be aware, however, that the asset class does tend to mirror the performance of the world stock markets. As a result, it can provide a measure of diversification for someone whose portfolio is heavily tilted toward stocks, but not as much as you might expect.
Dollar-Denominated vs. Local Currency Debt
Investors can choose between mutual funds and exchange-traded funds (ETFs) that invest in either dollar-denominated emerging market debt, or debt issued in local currencies. For example, in issuing debt a country such as Brazil can sell bonds denominated either in dollars or in the country’s currency – the real. Dollar-denominated debt tends to be more stable, while local currency debt is generally more volatile. However, local currency debt can, in the longer term, provide another way to capitalize on the strong economic growth and improving finances of emerging market countries. The option you choose depends on your tolerance for risk.
Corporate Bonds Versus Government Bonds
Investors aren't limited to just government bonds in the emerging markets. Corporations in the developing countries also issue debt, and this asset class is rapidly growing in popularity. While many emerging market funds put a portion of their assets in corporate bonds, investors can also access the asset class directly through ETFs such as WisdomTree Emerging Markets Corporate Bond Fund (ticker:EMCB).
Issuers of Emerging Market Bonds
A large, and growing, number of countries are issuing debt. Among the most prominent are:
- Dominican Republic
- El Salvador
- Ivory Coast
- South Africa
- Sri Lanka