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David Stevenson: want yield and diversification? Try these bonds

David Stevenson: want yield and diversification? Try these bonds

Why do you invest in fixed income securities or bonds? Is it because you want an income? Or is it because you want some diversification away from equities?

My guess is that most investors will probably answer 'yes' to both. But they face a brutal reality in that the income available isn’t great, especially if they invest in bonds which are viewed as ‘safe’ such as government securities or investment grade corporate debt.

Yields of less than 2% are pretty much standard. That sorry state of affairs – for bond investors at least – encourages them to move up the risk curve to riskier securities such as mainstream corporate bonds or even high yield credit (and junk bonds). The income is higher, which of course means that the chance of default is greater.

But there’s another risk, that investors lose the benefit of diversification. There’s a growing body of evidence which points to the fact that as you head up the risk curve, the correlation between risky assets (equities) and high yield bonds increases. So many corporate bonds might not offer diversification benefits for investors in an equity market crash.

Back in the real world, we still have to find a way to build a diversified portfolio of bonds – government securities as well as corporate bonds – so we 'make do', accepting the risks.

My suggestion for bond investors

If that is the case, I have a suggestion for bond investors. Think about emerging market bonds as part of a diversified portfolio of fixed income securities. I’m not suggesting that investors go crazy and suddenly allocate meaningful portions of their portfolio to these ‘riskier’ assets, but its not uncommon to see emerging market bonds forming 10% to 20% of an institutional bond portfolio.

The attractions of emerging bonds as an asset class are obvious - as are the risks. The big selling point in an era of 'low rates for longer' is the yield, which typically varies between 4% and 7% depending on the exact class of assets held.

Local currency bonds (assets denominated in everything from roubles to the South African rand) tend to command a higher yield because they are riskier, if only because of the likelihood of currency fluctuations. Even dollar bonds issued by local emerging markets corporates command a higher yield because the issuers are deemed to be riskier than sovereign states.

Dollar denominated bonds tend to command a lower yield given their lower currency risk, with sovereign dollar bonds yielding the least. These varying types of emerging market bonds remind us that investors need to worry not only about default risk but also currency fluctuations.

There’s also a slightly nebulous argument that as the profound global shifts intensify, with capital drifting to Asia and emerging markets generally, the balance sheet fundamentals of these emerging market borrowers will improve.

Put simply, much of the developing world has lower levels of debt than that of the ageing west. Sure, their currencies may be more volatile – though less so than in the past – but their credit worthiness may start to improve. And as the perception of that credit worthiness changes in our low interest rate world, the spread between safe bonds (US treasuries) and not-so-safe bonds (emerging market sovereigns) might tighten.

We’ve already seen a small hint of this in recent market moves. Average yields on US currency notes, for instance, have fallen about 74 basis points this year to 5.31%, but are still above the 2018 low of 4.47%, according to a Bloomberg Barclays index.

Last chance at diversification

One last argument might also offer itself: diversification. The chart below is from the online service Sharepad and shows returns over the last few years for the iShares JPMorgan USD Emerging Markets Bond ETF (SEMB) in sterling, against the FTSE 100 in red. In the box at the bottom you can see the 20-day correlation of this exchange-traded fund with the blue-chip UK equities index.

It varies, hugely. In some markets it's closely tied, in other, not. Most analysts reckon that a judicious investment in emerging market bonds offers investors one of the few last chances to diversify in an increasingly correlated world – the best argument for this world view came from The Economist's Buttonwood in an excellent recent column on the subject

There are of course some obvious 'challenges' for any investor looking to deploy money into emerging market bonds, most of them centred around foreign exchange risk. With local currency bonds, that risk is hard to ignore. South African government bonds might look attractive on paper – the current government 10-year bond yield is 8.52% – but you could easily lose all that income if the rand moves against you.

But even with hard currency, usually dollar denominated, debt there’s a risk. The dollar itself could weaken or strengthen. If it strengthens, it could push up the local currency value of that debt for the borrower, encouraging distress and defaults. And the dollar has generally been very strong in recent years, which has hit sentiment for emerging market bond holders.

There’s now talk that the dollar could weaken as the US Federal Reserve takes its foot off the interest rate accelerator, which could be good news for emerging market bond investors, but guessing what might happen next to the dollar is a bit like playing roulette.

What does the market tell us?

Better to list to what the market is telling us at the moment. Developed market dollar bonds have returned 5.4% in the first quarter of this year and inflows into funds are increasing. That’s been helped by the dovish tone of the of the Fed which should be most beneficial to emerging market local currency bonds.

Goldman Sachs analysts also suggest that the current backdrop for emerging market fixed income is 'benign, which is a confluence of global growth being just right and the developed-market rate cycle being supportive… there still seems to be some room for gains for emerging-market sovereigns'.

That’s a sentiment shared by bond analysts at Pimco who think the biggest opportunity is in 'the "divergent policies" of new governments in Brazil, Colombia, Malaysia and Mexico, and from fears surrounding key elections in Argentina, Indonesia, India and Ukraine'. If they’re right, that’s a strong argument for using an active fund manager who can invest across both local currency and dollar denominated debt and across many different geographies.

In summary, emerging market bonds represent a perfectly sensible alternative asset class for many mainstream investors. You need to be very aware of the risks and certainly don’t over indulge, but as a small part of a fixed income portfolio they might make sense, some of the time, for some investors.

When I talk to most private investors, they have almost next to no knowledge about the sector, and certainly no exposure. They assume that their strategic bond managers might allocate some hard cash to this sector but I’m not sure that is always the case – many of these managers only stick with mainstream developed world markets. And even if investors do have an interest, there’s real confusion about how to access it.

Funds and ETFs to pick from

The good news is that there is plenty of choice for prospective emerging market bond investors, most of it easily accessible via funds, either passive or actively managed. The first table below features a selection of the biggest (and cheapest) ETFs, broken down by category. Your main choice here is whether you want to invest in local currency bonds or aggregate dollar bond funds. One interesting choice is UBS JPMorgan EM Diversified Bond, which is hedged back to sterling, so removing some of the risk from the dollar moving around violently.

Category ETF Size Total expense ratio (%) 1-year return (%)
Emerging markets local iShares JPMorgan EM Local Government €8bn 0.5 1.2
  Pimco EM Advantage Local Bond €179m 0.61 3.1
Emerging markets aggregate iShares JPMorgan USD EM Bonds €7bn 0.45 13.9
  Xtrackers USD EM Bonds £1.3bn 0.25 n/a
  UBS JPMorgan EM Diversified Bond 1-5 years GBP hedged 51m 0.47 4.7

My own preference would be to opt for an actively managed fund. I think the choices between both hard and local currency, and corporate or government debt are tough ones and personally I’d run a mile from taking those kinds of decisions as a private investor.

Good active managers can figure their way through this maze of choices, pick countries they think are under valued and worry about what might happen next to the value of the dollar, all decisions I’d feel hugely underqualified to make a judgement call on.

Again, the good news here is that there are a fairly tight group of well-known names operating funds in this space and by and large their returns tend to cluster for this top tier of funds. In essence your major decisions are who you trust as a fund manager and what yield you want.

Fund Yield (%) Ongoing charges ratio (%) 1-year return (%) 5-year return(%)
M&G Emerging Markets Bond 6.8 0.79 8.1 60
Pictet Global Emerging Debt 5.3 0.87 10.8 57
Standard Life Investments Emerging Market Debt 4.6 0.82 9.2 53
Threadneedle Emerging Market Bond 6.7 0.74 8 50
Merian Emerging Market Debt 6.5 0.96 8.9 51

My own personal favourite, by a very narrow margin, would probably be the M&G fund. The group generally has an excellent record in fixed income and the fund has consistently delivered returns towards the top of its admittedly small niche. The charge is reasonable and the yield high.

But any of the top six funds I’ve listed could probably do the job for you, so dig around a bit and look at the what their current investment strategy is and how it fits with your view of the world.

Any opinions expressed by Citywire or its staff do not constitute a personal recommendation to you to buy, sell, underwrite or subscribe for any particular investment and should not be relied upon when making (or refraining from making) any investment decisions. In particular, the information and opinions provided by Citywire do not take into account your personal circumstances, objectives and attitude towards risk.

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