Emerging market bonds yielding over 5% beckon income investors

By Xavier Brenner

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Emerging market bonds are paying decent yields in a low-rate environment but many investors are wary of the sector due to recent gyrations in the currencies of developing economies.

The prospect of a modesty tighter monetary policy in the U.S., political turmoil from Ukraine to Thailand and disappointing data out of China have crushed emerging market currencies and bonds.

Small wonder then that investors are rushing for the exits when it comes to emerging market bonds. In the week through Feb. 12, outflows of bond funds reached $1.4 billion and they're down $8 billion for the year, according to Bloomberg, which cited figures by data provider EPFR Global.

The Goldman Sachs Local Emerging Markets Debt Fund (GIMDX), which has at least 80% of its net assets in sovereign and corporate debt of issuers located in emerging countries, is down nearly 3% on the year and off 14% over the last 12 months.

Will emerging market debt remain radioactive for the foreseeable future?

At the moment, these assets carry huge risks and lower credit ratings. Developing country debt faces a two-fold risk: hot money outflows and currency volatility.

Yet income investors who can stomach the risk may be drawn to the yields being paid by emerging market debt. For example, iShares JP Morgan USD Emerging Markets Bond ETF (EMB) and PowerShares Emerging Markets Sovereign Debt ETF (PCY) have 30-day SEC yields of more than 5%.

EMB Chart

EMB data by YCharts

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 generally viewed as improving as these markets mature.

According to data compiled by JPMorgan and Bank of America Corp., emerging market low currency debt returned 205 percent in dollar terms in the decade through 2012, compared with a 58 percent gain for U.S. Last year, domestic bonds in developing nations lost 6.3 percent, the most since 2002 when JPMorgan started compiling the data. And 2014 is looking like a tough one for emerging market bond investors.

Eaton Vance Investment Managers analyst, Kathleen Gaffney, in a post for Morningstar, writes of the diminished allure of the BRIC countries and fragile five markets in the developing world:

"With growth differentials between developed and developing markets narrowing, the emerging-market countries have come under considerable stress at the beginning of 2014. The so-called BRICs–Brazil, Russia, India and China–are no longer investment darlings and the bloom is coming off the sector. Indeed, one of these countries is now included in what has become known as the ‘fragile five’ (Brazil, India, South Africa, Turkey and Indonesia), which are grappling with current account deficits and struggling with fiscal discipline."

Optimists argue that much of the carnage developing world stock and bond markets represents a short-term shift into dollar assets ahead of Fed action to raise interest rates, though that is not likely until 2015. Also, the for the sharp-eyed investor with a high tolerance for risk and long-term perspective, there may be quality emerging market bond funds and corporate debt that may be attractive on a valuation basis.

The good news, if you can call it that, is that institutional investors haven't bailed out on emerging market debt just yet. Most of the selling is from retail investors. Developing-country companies and governments have sold $67 billion in dollar-bond sales this year, according to data compiled by Bank of America analyst Jane Brauer. Foreign investors also boosted their holdings of local-currency bonds by 7 percent between July and December, according to Brauer.

Sergio Trigo Paz, head of BlackRock's emerging markets fixed income group, recently told the Financial Times that investors should stick with U.S.-dollar denominated emerging market ETFs to hedge against developing country currency risk.

Two popular U.S. dollar-denominated emerging market bond ETFs, according to Max Chen with ETF Trends, are the previously-mentioned iShares JP Morgan USD Emerging Markets Bond ETF (EMB) and PowerShares Emerging Markets Sovereign Debt ETF (PCY). Over the past year, both have performed far better than the WisdomTree Emerging Markets Local Debt Fund (ELD), which is exposed to local currency risks.

There's no denying that emerging market debt is a very high risk proposition at the moment. Still, Charles Sizemore, who manages the Global Macro and Tactical ETF portfolios, thinks the emerging market sell-off may be overdone.

"With emerging-market indexes in freefall and investor sentiment toward them as negative as I have seen in years," Sizemore noted in a recent post for Covestor, "we're very close to getting buying opportunities in some of my favorite emerging markets."

Many emerging market currencies have weakened against the U.S. dollar this year, but the chart below of WisdomTree Emerging Currency Strategy ETF (CEW) has firmed up a bit recently.

CEW Chart

CEW data by YCharts

The bottom line is that emerging market bonds can be risky and volatile, but they also offer above-average yields and some diversification benefits.

"The emerging-markets debt space has become increasingly popular in recent years. Excellent returns over the last decade and growing distrust of developed-markets sovereigns have combined to increase the appeal of emerging-markets bonds," writes Morningstar analyst Timothy Strauts in a report on iShares JP Morgan USD Emerging Markets Bond ETF (EMB).

"Emerging-markets bonds historically have proved to be a good portfolio diversifier. During the last three years, the correlation between EMB and the Barclays U.S. Aggregate Bond Index has been 0.31," he added.

Photo Credit: Diego3336

DISCLAIMER: The investments discussed are held in client accounts as of January 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. International investing involves special risks, such as political instability and currency fluctuations. Past performance is no guarantee of future results.