"Emerging-market bonds for the long run" doesn't exactly flow from the lips. Buying emerging-market debt on the eve of war in the Middle East might sound counterintuitive, but it might not be as risky as it seems, given the sector's history of overcoming short-term upheaval.
Recent discussions about the long-term performance of stocks vs. Treasuries have obscured the broader truth about the ongoing long-term strength of emerging-market debt. For the 10 years ended Feb. 28, emerging-market debt produced cumulative annualized returns of 11.32% vs. 7.45% for U.S. Treasuries and 6.75% for the
, Merrill Lynch reported last week. In the same time period, emerging-market equities lost nearly 7%. (The results are for Merrill's Emerging Markets Sovereign Debt Index, which is similar to the J.P. Morgan Emerging Markets Bond Index, or EMBI, the most common benchmark for the sector's portfolio managers.)
Emerging-market debt also bested Treasuries and, thus, U.S. stock proxies in the past year, consistent with its long history of outperformance, as indicated by the chart below.
The Merrill study further noted that emerging-market debt posted those 10-year returns "despite the almost annual global crises," including Mexico's peso crises in 1994, the Asian tigers in 1997, Russia's default in 1998 and more recent crises in Argentina and Brazil. Furthermore, EM debt holders were rewarded "even entering the market during the year before those crises," the report concluded.
Theories abound about how and why emerging-market debt has survived and prospered despite those destabilizing events.
Tulio Vera, chief emerging-market debt strategist at Merrill, noted the aforementioned cumulative returns include a negative year in 1994 and a 15% decline in 1998, after Russia's default. But following that event, which trigged Long-Term Capital Management's unraveling, the EM debt market became "a lot leaner," Vera said. That is, it was less in the hands of speculators and became more an arena for "buy and hold-type investors with a greater emphasis on sovereign credit analysis," i.e., the fundamentals, he said.
Mark Dow, who co-manages $600 million in emerging-markets debt for MFS, including the
MFS Emerging Markets Debt fund, believes the persistent path of reform is key. Comparing an emerging-market nation to a corporation retooling an inefficient cost structure, Dow said "the top line doesn't have to grow to improve earnings."
For sovereign nations, "do reforms and reduce inefficiencies, and
the debt performance will be fine," Dow said. "It's more important than any
Then again, both Dow and co-manager Matthew Ryan each worked at both the International Monetary Fund and U.S. Treasury before joining MFS, so their focus on reform as the key is understandable.
Jane Brauer, head of emerging-market quantitative strategy at Merrill, offered a (not surprisingly) less qualitative explanation. First, even nations that defaulted, most notably Russia, bounced back sharply and in fairly short order, she noted, meaning investors who didn't sell were ultimately rewarded.
Second, there is "always a cushion for spread tightening" in EM debt, Brauer said. That's because there are countries such as Mexico and Poland that "graduate" to investment grade and are moved "up and out" of indices, only to be replaced by lower-rated issuers like Turkey, the Philippines and Colombia.
The emergence (get it?) of these presumably riskier nations helps keep the spread between emerging-market debt indices and Treasuries at levels that attract a constant stream of capital; i.e., demand for the EM debt.
The current spread of about 700 basis points above Treasuries for the J.P. EMBI-Plus is below the five-year average of around 850, Vera noted. But it's also well above the lows of around 450 basis points before the Russia crisis and last year's low of 600, he said. "There's still potential for spread tightening," i.e., outperformance vs. Treasuries, "and even if we don't tighten, the pure return of clipping coupon(s) is very attractive still."
That's another way of saying EM debt's run isn't about to end. Here's a (far) more anecdotal reason why you shouldn't worry you're about to get in after the getting was good: When I wrote about emerging-market debt back in
late January, reader reaction was tepid, certainly less than if I'd written about
or homebuilding stocks.
Clearly, many investors -- or at least
readers -- remain focused on past glories in equities rather than possibilities in other asset classes.
One of the most appealing aspects of emerging-market debt is the notion "you don't have to make a bet on the U.S. economy to like the asset class," Dow said. EM debt "is the only asset class where you don't have to decide on that big question.
It seems well insulated."
Wary, but Not Worried About War
Of course, with war looming in the Middle East, the question arises whether the sector is on the cusp of another "crisis" that can cause a short-term dent in the stellar long-term track record. The best-performing subsector of EM debt in the past decade was one that includes Eastern Europe, the Middle East and Africa, according to Merrill. It's not illogical to think at least two of those areas would get hurt if any war against Iraq is protracted, or "winning the peace" proves harder than expected.
"That's a possibility, but not the most likely scenario," Vera said, referring to consensus expectations for a short war. Furthermore, "even if war is short, we're still looking at a U.S. economy that is very sluggish," with 2% GDP growth in 2003 and additional
rate cuts. Merrill is still cautious on the U.S. stock market and Vera has seen a "disillusionment with equities as the asset class of choice," leading investors to gravitate toward "spread product" such as EM debt.
MFS' Dow largely agreed, adding that -- save for Turkey -- the market caps of Middle Eastern and African issuers are so small they're unlikely to materially affect EM debt indices.
Of course, if Turkey (or Israel) is dragged into the fray, or extracting Saddam Hussein's regime proves more difficult than expected and destabilizes the region, all financial markets are likely to take a hit. Because of expectations for a short war accompanied by a sharp rally, equities would probably get hit harder than EM debt if "the unexpected" occurs. A best-case scenario for the war might ultimately hit EM debt the hardest because it would rekindle appetite for risk, which currently means tech stocks more than, say, Hungarian debt.
How's that for counterintuitive?
Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to
Aaron L. Task.