As the developed nations continue to punish savers by pounding yields below the zero bound there are some interesting alternatives in the emerging market bond funds.
Already one third of all developed nations’ sovereign debt, some $13 trillion worth including German, Swiss and Japanese bonds, now sporting negative interest rates. This leaves retiring baby boomers, pension funds, insurance annuities and anyone seeking stable income in a desperate state.
Thus far investors have been piling into dividend paying stocks such as utilities, consumer staples and REITs as these stocks have been treated as “bond equivalents.” But this has pushed valuations to hit historical highs making further gains unlikely. Remember, it doesn’t take too big a dip in share price to wipe out a year’s worth of a 3% dividend—no matter how seemingly stable their businesses is they still carry stock risk.
After the German bund went negative and the Brexit weakened the pound, money came rushing from Europe into the U.S. bonds for their relatively high yield; this has driven yield the 10-Year Note down below 1.5% in recent weeks. I believe a similar arbitrage will cause money to flood into emerging market bonds as money seeks the higher yield differential they offer.
This image shows there is still a wide spread between yields on developed nations vs. emerging market bonds.
This has not gone unnoticed as money has been flowing into emerging market bond funds in recent weeks. A record $4.9 billion was allocating to such funds in just the past week alone bringing the year to date total above the $50 billion mark.
Back in the late 1980’s and 1990’s emerging market bonds–that is bonds issued by the governments such countries such as Brazil, Mexico, India, etc.–were considered both risky and exotic.
The former because the countries truly were just “emerging” with many having unstable governments, minimal economic output and rampant inflation often in excess of 30%. All this added up to a high risk of default. Because of this risk investors got paid with bonds that offered annual yields of 10%-15% and sometimes more.
They were considered exotic because only the largest institutions or sophisticated investors had access. One needed to be able to purchase the bonds directly from the local government or their local intermediaries. Not many U.S. based investors can open Turkish, Malaysian or Chilean bank accounts, let alone all three or more.
The risk issue has greatly diminished as the countries’ governments have stabilized, the economies’ improved and inflation came down to at least more manageable levels.
These bonds became less exotic as globalization spurred capital, both corporate expansion and speculative investments, to flow to where it would be best paid. In the early 2000’s that meant into emerging markets, made well known by the ‘BRIC’ acronym, where the demographics of youthful population, urbanization and incipient consumer driven middle class were delivering double digit GDP growth.
But it took the financial crisis to make investing in these bonds accessible to U.S. retail investors. During the crisis of nearly all asset classes, from equities to commodities, and of course real estate suffered. Leaving investors that thought they were diversified discouraged. The one safe haven was U.S. Treasuries.
But then rate cuts and QE programs drove yields down to starvation levels. So as the crisis passed investors started looking for not only higher yields but ways to diversify. And the financial industry was there to oblige by launching a host of emerging market ETFs which bundled a bunch of bonds providing some price stability but still delivered attractive yields.
Today there a number of ETF’s such as PowerShares Emerging Market Sovereign Debt (PCY) and iShares JPMorgan USD Emerging Markets Bond (EMB) that each have over $8 billion in assets under management (AUM).
They pay dividends with a current approximate yield of 5% per year and each trade over 1 million shares a day providing good liquidity. Additionally, the shares have been on a tear, enjoying capital appreciation of some 10% thus far this year and all sit near 52-week highs.
Some ETFs that focus emerging markets bonds denominated in local currencies include Market Vectors Emerging Markets Local Currency (EMLC) and Wisdom Tree Local Debt (ELD) and iShares Emerging Market Local Currency Bond (LEMB).
All of these funds own government issued bonds that have an investment grade rating and the yield is simply the coupon payment. They offer some 5% dividend yield and have decent liquidity for easy transactions.
While much of luster has left the BRICs of late they still have several positives going for them; decent, if unspectacular growth rates, increasingly diversified economies with growing middle classes and, except for a few nations which have become untouchable, peaceful and stable governments.
But most importantly their Debt levels are far lower as a ratio to GDP than any of the developed nations. For example, while household debt to GPD in the U.S., Japan and France are all above 100% it stands at just 9% in India, 22% in Brazil and 31% in Mexico. Emerging market governments have accumulated less dollar debt, built up foreign reserves and adopted flexible exchange rates to obviate mistakes during the 1980s and 1990s crisis.
Blackrock has recently been recommending investors take the theme a step further and suggests investing in these bonds using the local currency writing in a recent report, “Developing countries such as Brazil and the original Asian Tigers all took their medicine two decades ago and now have much better balance sheets than the developed world.”
The developed nations continue to punish savers by pounding yields below the zero bound. For those looking for yield and diversification away from the dollar these funds make sense.
Steve Smith is an expert options trader with 25 years experience in the markets. Steve was a seat-holder of the Chicago Board of Trade (CBOT) and the Chicago Board Option Exchange (CBOE) from 1989 – 1997. Steve is currently the editor of The Option Specialist and runs the 20K Portfolio Program which provides all types of options trades for all types of traders.