Income diversification: Are emerging market bonds worth a look?

29th February 2016

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At their best, emerging markets can offer access to a basket of high growth economies with favourable demographics, geographic diversity and returns that potentially far outpace many developed markets writes Darius McDermott, Mindful Money columnist and managing director of Chelsea Financial Services…

The most famous cluster of emerging markets, the BRICS, comprises Brazil, Russia, India, China and South Africa – although the investment landscape is much broader than these five.

Most of the time, you’ll hear about investing in countries such as these via equities and with the Chinese share market making news for all the wrong reasons over the past six months, it’s no surprise people are wary.

But there’s a whole other side to emerging market investing through bonds. With several managed funds in this space currently delivering yields in excess of 5%―compared to an average in the sterling strategic bond sector of around 3.6%1―are they worth a look?

What do you need to know?

Broadly speaking, there are a couple of key factors you should be aware of across all emerging market funds when it comes to choosing an investment.

The first is the types of bonds the fund holds. Just like developed nations, emerging markets offer bonds issued by both governments and companies. As governments typically have less chance of defaulting on repayments (than corporates), government bonds are generally lower risk. The more corporate bonds a fund holds, the riskier it becomes.

The second is the fund’s currency exposure – or in other words, whether its bonds have been issued in ‘hard’ currency (usually US dollars), or the local currencies of the countries in which it invests.

Hard currency has long been investors’ preference as it reduces the volatility caused by foreign exchange fluctuations. However, over the past couple of years, the US dollar has strengthened considerably against emerging market currencies.

When this happens it becomes harder for these countries (government or corporates) to repay their debts, which are now more ‘expensive’ relative to their local revenue. The chances of default go up, which means the bonds become riskier.

In the short-term, this can give income returns a boost, as it drives up the yield as bond prices fall. In the long run, though, if issuers can’t repay the principal bond amount, it’s not such good news.

For example, you may recall towards the end of last year the Commonwealth of Puerto Rico announced it was unable to meet pending loan repayments. Investors were forced to accept a mixture of total defaults and restructuring with reduced repayments and extended maturity dates.

China and commodity concerns

A leading concern in this vein at the moment is China. Its burgeoning corporate loans, in particular, are raising red flags. The private sector debt to gross domestic product (GDP) ratio rose by roughly 80% over the ten years to end June 20152, meaning more companies are borrowing (and they are borrowing more) relative to the size of the economy.

Corporates are taking steps to mitigate the risk of drastic currency depreciation, refinancing offshore debt into onshore (local currency) bonds. Mind you, domestic debt could also become a burden for Chinese firms if economic growth continues to slow at its current pace.

Another worry is the flow-on effect created by China’s slowing demand for resources, evident in both developed and emerging markets – particularly those of hard metal exporters, where companies borrowed heavily to pump up production.

Iron ore miners in countries such as Australia and Brazil have been hit hard, for example, following huge commodity price falls. Bond holders in Australia’s third largest iron ore miner, Fortescue Metals, had a rough 2015 as the company struggled to get its significant US$ debt under control.

Fortescue was forced to employ measures including issuing new bonds to redeem existing debt and buying back bonds at, in some cases, less than 80% of their face value in order to save on interest payments.

The asset price falls created by these kinds of problems can quickly become contagious, especially in more fragile emerging market economies.

When you’re choosing a fund, you therefore want to be looking for an experienced manager with a strong track record of recognising and avoiding these kinds of pitfalls, and selecting investments prudently in a range of market conditions.

Is now the time to invest?

Despite these concerns, emerging market bond funds have returned an average 2.5%3 throughout a volatile January and February-to-date – compared to negative returns across a range of other fund sectors including sterling strategic bonds, emerging market equities, global equities and UK all companies.

We’ve been cautious on emerging markets for some time, and the consensus view is that asset prices, which have been more or less falling over the past few years, still have further to fall.

That said, if the tables do start to turn, emerging market bonds could be an attractively-priced investment this year, with a more acceptable risk profile. Of course it’s important to remember they will always be more risky than bonds in developed markets.

If you’re thinking about dipping a toe in the waters, go in with a minimum two to three year time frame and be prepared for further falls in the short term.

FundCalibre’s Elite Rated funds in this space include Standard Life Investments Emerging Market Debt and Aberdeen Emerging Markets Bond.

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