Bond Portfolios Under Stress: Taking the Hunt for Income Overseas
By Hal M. Bundrick
NEW YORK (
)--As the flight from domestic bonds goes supersonic, investors are rapidly broadening their search for income producing alternatives. Taking that hunt overseas is one option gaining favor among investors. Barclays estimates that emerging market debt is now valued at $2.7 trillion, with a majority of the offerings rated as investment grade. For the five-year period ending in 2012, more that $64 billion in new investments were placed into emerging market debt mutual funds and exchange-traded funds, with almost $28 billion of inflows in 2012 alone, according to Morningstar.
"International bonds are a major asset class, larger than international stocks, U.S. stocks, and U.S. bonds," says Chris Philips, Vanguard Senior Investment Analyst. "At their root, highly graded bonds can be an effective diversification tool in reducing the risks of investing in global equity markets. U.S. investors have seen this relationship play out during the two bear markets and bouts of volatility since 2000. With international bonds, we would expect additional diversification because the return drivers for global bonds and U.S. bonds have not been highly correlated."
Read: The Price of Fraud
More than 90% of the debt is issued by governments or government-related entities in countries such as Brazil, Russia, India, Turkey and China. Philips says that while the fixed income market in the U.S. has been fraught with low yields and an outlook of meager returns at best, bonds in many emerging market countries have offered attractive yields and strong historical performance against a backdrop of improving macroeconomic fundamentals.
"Fixed income's role as a diversifier against riskier assets can have a significant effect on a portfolio," says Philips. "It's true that a lot has happened in the global markets in recent years--the Eurozone crisis, Japan's deflation, the downgrade of the U.S. credit rating. Yet investors who avoided global markets during this time didn't necessarily fare better than those who didn't. In fact, despite all the recent international turmoil and uncertainty, a portfolio that included exposure to both U.S. and foreign bonds (assuming the currency exposure was hedged) would have experienced a less volatile ride than a portfolio focused only on the United States."
Read: Think Twice About Social Security for Early Retirement
Of course, investing in emerging market debt doesn't come without its risks, which can include sensitivity to political events and financial uncertainty. Vanguard's research indicates that emerging market bonds perform more like stocks, exhibiting greater volatility than traditional investment-grade bonds.
--Written by Hal M. Bundrick
Read: Open Classrooms Can Change the Course of Your Career