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The Higher Yields Of Emerging Market Bonds May Be Worth The Extra Risk

By John Spence

Interest rates have moved up in recent months, but we’ll forgive income investors for not rejoicing. The benchmark 10-year Treasury note still yields less than 3%.

Generating income has been a challenge in a low-rate environment, but one solution for U.S. investors is to broaden their horizons. Specifically, the higher yields of emerging market sovereign bonds could justify the risk for investors who are comfortable with holding non investment-grade debt.

"Emerging market bonds are also a diversification play," said David Cowles, director of investments at Mosaic Financial Partners. Mosaic manages the Strategic Asset Allocation portfolio on Covestor.

Emerging market debt is less correlated with Treasury yields than various types of U.S. bonds such as corporates and municipals, Cowles said. For example, the iShares JPMorgan USD Emerging Markets Bond ETF (EMB) has had a relatively low correlation of 0.31 with the Barclays U.S. Aggregate Bond Index the last three years, according to Morningstar.

Emerging markets also have lower debt-to-GDP ratios than developed economies, Cowles added.

Aside from diversifying a portfolio of U.S. bonds, the asset class has delivered solid absolute returns over the past decade. The J.P. Morgan Emerging Markets Bond Index Global, the benchmark for Fidelity New Markets Income Fund (FNMIX), had a 10-year annualized total return of 8.7% as of Sept. 30.

Most individuals are underinvested in emerging market bonds. Even large defined-benefit plans had only 2% in international fixed-income as of March 2012, according to the Wilshire Trust Universe Comparison Service.

Yet the fiscal and debt challenges faced by developed economies have more investors at least considering emerging market bonds. The Eurozone is still trying to shake off its debt crisis while the U.S. is in the midst of its latest debt-ceiling showdown.

Emerging market sovereign bonds tend to have lower credit ratings, but the asset class has some positive tailwinds compared to developed economies. These include faster economic growth, lower debt levels and deficits, and better demographics. Also, liquidity and credit quality are improving as these markets mature.

Of course, there are important risks investors need to consider when holding emerging market bonds, and the financial crisis was a clear reminder of the potential dangers of reaching for yield by taking on more risk.

Emerging market bonds historically have been more volatile than U.S. Treasuries and other developed market sovereign debt. The iShares JPMorgan USD Emerging Markets Bond ETF (EMB) has a five-year standard deviation of 11.38, versus 3.66 for the Barclays U.S. Aggregate Bond Index, according to Morningstar. In recent years, emerging market bonds have also been hit hard when markets experience "risk-off" episodes. Weakness in commodity markets and currency depreciation are other key risks for this fixed-income asset class.

Additionally, emerging market bonds are not immune to rising U.S. interest rates. The sector fell sharply during the spring of 2013 as U.S. Treasury yields surged on expectations the Federal Reserve would taper its bond purchases. Emerging market bonds have recovered some of those losses with the Fed announcing it would off on tapering after the September meeting.

Emerging market bonds have higher yields to compensate investors for these various risks. The iShares JPMorgan USD Emerging Markets Bond ETF (EMB) is currently paying a 30-day SEC yield of 4.90%, while the U.S. 10-year Treasury note yields about 2.7%. Yields in emerging market sovereign bonds are on par with their averages between 2003 and 2007, while U.S. Treasury yields are well below that period, Barron's notes. This wider yield spread means emerging market bonds could be attractive relative to developed markets on a valuation basis.

There are several exchange traded funds that invest in the sovereign debt of developing economies. One key difference among these ETFs is whether they hold bonds denominated in U.S. dollars, or the local emerging market currencies.

The iShares JPMorgan USD Emerging Markets Bond ETF (EMB) and PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) provide exposure to emerging market government bonds denominated in U.S. dollars.

WisdomTree Emerging Markets Local Debt Fund (ELD), Market Vectors Emerging Market Local Currency Bond ETF (EMLC) and iShares Emerging Markets Local Currency Bond ETF (LEMB) track bonds denominated in the issuing country's currency. These ETFs may provide some currency diversification for U.S. investors, but tend to be more volatile than the funds that follow U.S.-dollar-denominated bonds.

Disclaimer: All investments involve risk and various investment strategies will not always be profitable. International investing involves special risks, such as political instability and currency fluctuations. Past performance does not guarantee future results.

Mosaic Financial Partners

Mosaic Financial Partners

Mosaic Financial Partners is a San Francisco based RIA serving high net worth individuals. It has $350 million in AUM

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