High yields come with high risks in emerging markets

Emerging markets are changing in a positive way. Corporate fundamentals are generally improving across the sector, and emerging market companies are deleveraging or paying off debt, which suggests they are becoming more financially robust and less risky, so could move to a higher credit rating.“[Emerging market debt] also offers the opportunity for capital appreciation from both growth and currency appreciation," adds Rory McPherson, head of investment strategy at Psigma Investment Management. "Currency appreciation can account for one-third to half of a bond's yield if it is bought in local currency. This year has been really good in this respect, because the pound has been really weak while emerging market currencies have strengthened, meaning that bonds have been one of the best performing assets this year.” 

Emerging market bonds are denominated in either the country’s local currency or in US dollars. The latter, which are sometimes referred to as hard currency bonds, tend to be less risky and therefore higher rated because they do not have the same volatility as local emerging market currencies.

Although both corporate and government bonds carry credit risk, it is typically much higher for corporate bonds and reflected in their higher yields. "Emerging market government default rates are historically low and sovereign balance sheets are generally much healthier," explains Gene Frieda, global strategist at investment management firm PIMCO. “However, although the historic default rate for high-yield corporate bonds is 2.5 per cent, looking forward we see it coming down to 1 per cent.”

Emerging market bonds have recently outperformed UK bonds. Bloomberg Emerging Market Corporate Bond Index GBP hedged, which tracks hard currency emerging market bonds, has returned 7.46 per cent over one year and Barclays EM Local Currency Core Net Total Return index, which tracks local currency emerging market bonds, has returned 12.99 per cent. FTSE Actuaries UK Conventional Gilts All Stocks Total Return Index, which tracks UK government bonds, has returned 5.21 per cent over one year and iBOXX Sterling Corporates Overall Total Return Index, which tracks sterling corporate bonds, has returned 7.32 per cent.

And the long-term outlook for emerging market debt looks good. The US central bank, the Federal Reserve, appears to have stopped increasing interest rates for the time being and the European Central Bank (ECB) has indicated that it will do more quantitative easing – buying bonds to increase market liquidity. The ECB will also have a new president in October – Christine Lagarde – and Mr McPherson believes that her reputation for implementing very accommodative policies will help.

Although emerging market debt valuations were cheaper at the end of last year Mr McPherson says you could invest set amounts of money on a regular basis into emerging market bond funds. This way, you buy more when their units are cheaper and less when their units are more expensive. 

Higher returns entail higher risks

But while emerging markets can offer higher returns than developed markets, they are also higher risk. “Emerging market bonds are a riskier area of the bond market in the same way that emerging market equities are considered to be a riskier area of equities,” says Adrian Lowcock, head of personal investing at Willis Owen.

One major risk is political volatility. Last year, for example, concerns over the independence of Turkey’s central bank, escalating trade tensions between the US and China, and the possibility of American trade tariffs on Mexico affected valuations in these regions.

Emerging markets that are not having problems can also be affected by negative market sentiment due to events in other emerging market countries, although this is slowly changing. “Previously, the emerging market economies used to trade as a block, but now people are differentiating more between countries, which is a good sign that these markets are maturing,” says Victoria Hasler, director of research and consulting at Square Mile.   

Macroeconomic volatility is another major risk. Last year, for example, rising US interest rates made it more difficult for hard currency bond issuers to make repayments and the rumblings of an economic crisis in Argentina meant that the country had to take a loan from the International Monetary Fund to help pay off its maturing bond issues.

Mr McPherson says that investors also need to be aware of the additional cost of hedging emerging market bonds – the process of removing currency risk. At the moment, this is particularly high with hard currency bonds because sterling has been trading low against the US dollar due to uncertainty over Brexit, and hit a two-year low against the dollar last week.                    

This means that emerging market bond funds are not investments for the faint hearted. Due to their high risks, Darius McDermott, managing director of research firm FundCalibre, says they are best suited to experienced investors who can handle an element of risk.

Mr Lowcock adds: "Although emerging market bonds have matured as an asset class, they are more suited to experienced investors with larger portfolios. [These kinds of investor could have] around 5 per cent of their overall portfolio and maybe up to 20 per cent of their bond exposure in emerging market bond funds.”

You also need to hold emerging market bond funds over a long time period because the asset class is prone to volatility, so when assessing them look at their returns over periods such as five and 10 years.

Funds to access emerging markets bonds

If you have the necessary risk appetite and time horizon to include emerging market bond funds in your portfolio, options include M&G Emerging Markets Bond (GB00B4TL2D89). This fund has been managed by Claudia Calich since December 2013 and deputy manager Charles De Quinsonas, an emerging market corporate bond specialist, since September 2015. They aim for income and capital growth by investing at least 70 per cent of the fund in bonds issued by governments and companies in emerging markets. The fund invests in both hard and local currency bonds, and currently has 43 per cent of its assets – its largest exposure – in hard currency government bonds.

Ms Hasler says: “The fund's managers allocate across various parts of the emerging market debt universe, meaning that investors [in this fund] can gain access to the whole market."

The fund's managers pick bonds by first examining global and country-specific macroeconomic factors, and then conducting in-depth analysis of individual bonds. The fund’s largest country exposures are Mexico and the US.

So far, this strategy has worked well: over five years it has returned 69.33 per cent, compared to the Investment Association (IA) Global Emerging Markets Bond sector average of 27.03 per cent. And it has an attractive 12-month yield of 5.89 per cent.

Mr McDermott suggests Ashmore Emerging Markets Short Duration Fund (LU1076352977), which was launched in 2014 and invests in corporate, sovereign and quasi-sovereign bonds. The fund is run by Ashmore Group, which specialises in emerging markets and has over 20 years experience in the region. The fund is run via a team approach, rather than a lead manager and supporting analysts.

Its management team has a network of contacts in emerging markets, including banks and policy-makers. It begins its investment process by focusing on global and local macro-economics, politics, interest rates and currencies, before looking at individual bonds. An important consideration is how willing bond issuers are to pay back lenders – as well as their ability to do so. They only invest the fund in bonds denominated in US dollars and currencies of G7 countries.

The fund's managers invest the fund in bonds with a duration of between one and three years because they think this helps to reduce political and currency risk, and prefer to hold bonds to maturity. The fund has a high 12-month yield of 6.49 per cent.

Mr Lowcock likes Investec Emerging Markets Local Currency Debt Fund (GB00B58SJV49), which was launched in June 2006. It is managed by Werner Gey van Pittius and Antoon de Klerk, who aim for income and long-term capital growth.

The fund is primarily invested in local currency government and corporate bonds. Mr Lowcock says: “The managers combine their outlook for the different emerging market countries with individual company and bond analysis to build their portfolio. A lot of attention is spent on knowing when to sell stocks, with triggers in place to alert the fund's managers of risks.”

Over three and five years the fund has returned 19.1 per cent and 21.04 per cent, against 18.98 per cent and 31.32 per cent for JPMorgan GBI-EM Global Diversified index. It has a 12-month yield of 5.72 per cent.

The fund's largest geographic allocations are Brazil, Mexico and Indonesia, and its largest holdings include Mexican, Brazilian, Polish, Hungarian and Malaysian government bonds.

Mr Lowcock also suggests Legal & General Emerging Markets Government Bond (US$) Index (GB00B7GWV161), a passive fund that tracks JPMorgan Emerging Markets Bond Plus index. “This is a strong option for investors seeking exposure to US dollar denominated emerging market government bonds, and a key factor in this fund's favour is its low ongoing charge of 0.29 per cent,” he says.

Over three and five years it has returned 16.97 per cent and 59.13 per cent, against 16.46 per cent and 65.15 per cent for JPMorgan Emerging Markets Bond Index Plus. It has tracked this index closely over shorter-term periods and has a 12-month yield of 4.48 per cent.

At the end of May, its largest country exposures were Mexico, Turkey, Indonesia and Argentina.