Emerging Market Bonds: Less Risk Than You Think

by Jason Jenkins

Emerging Market Bonds: Less Risk Than You Think

One question on many investors’ minds right now is how to beat inflation. U.S. Treasuries and certificates of deposit obviously can’t cut it right now…

There’s a simple reason investors are flocking to the dividend market – savers don’t want to lose their purchasing power.

But lately there’s been a new trend for yield chasers overseas and it may be less risky than you think. Returns over inflation look very attractive right now. For the first quarter for 2012, the average emerging bond fund tracked by Morningstar returned 7%, versus 0.3% for the Barclays Capital U.S. Aggregate Bond Index.

But Why Emerging Market Debt?

Some fund companies offer two types of emerging market bond funds: those that invest mainly in bonds issued in U.S. dollars and those that invest mainly in bonds issued in local currencies.

Dollar-denominated foreign bonds have been on the rise and they attract those who are a little hesitant about currency risk.

Because of lower borrowing costs, companies from nations such as Brazil, Russia and Indonesia are diving into the U.S. debt market.

This is a good thing for potential investors in the market. Emerging market firms issued a record $75 billion in dollar-denominated bonds in the first quarter, a 40% spike over the same period last year.

The extra bonds out there have given investors a way to get higher yields than what’s available at home. The “yield chasers” have pumped in $14 billion into emerging markets bond funds in the first quarter, the most since the third quarter of 2010.

Emerging Market Companies Are Maturing

Have corporate bonds in emerging markets become fashionable because of a herd mentality? Or have we here stateside gotten over our developed country bias?

Bonds have been proven to add true diversification to portfolios. Also, bond issuers – countries and companies – in developing markets are maturing. By some measures, their bonds look more attractive than those of the developed world.

In a March research paper, Christopher B. Philips and colleagues in Vanguard's Investment Strategy Group found that a well-diversified portfolio that includes an allocation to hedged international bonds may could help get rid of overall portfolio volatility.

The study showed that investors could benefit from allocating at least 20 to 40% of their fixed-income holdings to international bonds. Emerging market bonds could be part of that allocation for risk-tolerant investors, Mr. Philips said.

What scared a lot of investors from international bonds are interest rate risk, shady political regimes and policies, and the economies of many different markets. Mr. Philips’ team found that the things driving international bond prices are relatively uncorrelated to those same things in the United States. That’s key as a diversification benefit.

What You Need to Weigh

Things you need to be wary of overseas:

  • We may have more bonds out there, but a lot of money managers are buying them up quickly. It may be too quickly. Yields on emerging market corporate bonds have fallen 1.5 percentage points since October, according to J.P. Morgan data.

  • This is a new market. There’s a short time frame for evaluating these types of bonds with their U.S. counterparts.

Some things that may allow you to overcome your concerns:

  • Developing countries are expected to expand 5.75% through next year. That’s almost four times the growth projected for the developed world, the International Monetary Fund says.

  • The payout on the J.P. Morgan Corporate Emerging Market Bond Index Broad Diversified, which has an average triple-B credit rating, currently averages 5.6%. That’s 1.1 percentage points above similar rated U.S. corporate bonds.

Among funds tracked by Morningstar, there are no index mutual funds for emerging-market bonds yet. Index ETFs investing in emerging market bonds are available, but as we’ve written many times before, watch out for leveraged bond funds. One new option to note, iShares invests in an index of dollar bonds based on the J.P. Morgan USD Emerging Markets Bond Fund (NYSE: EMB).

Good Investing,

Jason Jenkins

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