Fixed income investment's steady coupon payments, predictable returns and volatility smoothing abilities have made them the choice for a variety of cautious applications. For many portfolios, bonds form the conservative anchor and both treasury and sovereign bonds have formed that backbone. However, Europe's continued troubles with the PIIGS, America's recent credit downgrade and housing issues in Australia have all pointed to one thing: developed market debt may not be as "safe" as investors once thought. To that end, investors looking for safer bonds may want to look towards the emerging world. (For more, read Should You Invest In Emerging Markets?)
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A Re-Pricing Of Risk
Over the next few years, bonds issued by emerging market nations will become more attractive than their developed market sisters. The key to this outperformance lies within lower debt-to-GDP ratios. Unlike the United States, which has debt-to-GDP ratio of about 101% or Japan, the majority of emerging market countries often have lower debt-to-GDP ratios. For example, Brazil has a debt-to-GDP of approximately 60% and Malaysia is only around 35%.
These manageable ratios stem from strong balance sheets, fiscal responsibility, strong commodity resources and overall superior long-term prospects. According to the IMF, the aggregate ratio of debt-to-GDP for advanced economies has risen from around 46% in 2007 to more than 70% in 2011. This number will expand to 80% by 2016. However, for emerging markets, the aggregate ratio is currently 21%, after which it will gradually decline.
These strong fiscal catalysts have helped emerging market nations see 35 credit upgrades throughout 2011. This is a stark contrast to the 32 downgrades and zero upgrades for various developed markets during the year. Since 2008, there have been more than 118 upgrades in emerging bonds compared to 68 downgrades in the developed world. Yet, emerging market bonds still trade at higher yields and risk premiums than developed market bonds. This is despite the falling repayment and political risks. Overtime, this risk premium should diminish and there is some evidence that it is happening. Between December 2002 and August 2011, local currency emerging market debt produced returns of 13.6% while dollar-denominated emerging market bonds returned 10.7%. This compares to just a 7.1% return for developed market sovereigns.
With the potential for emerging market bonds to outperform and become a "safer" bond option, investors should consider the space. While buying individual, corporate or treasury bonds is quite easy, adding individual emerging market sovereigns is almost impossible. Luckily, just as funds like the SPDR Barclays Capital International Treasury Bond (ARCA:BWX) and PowerShares DB Japanese Government Bond (ARCA:JGBL) provide access to developed market debt, there are plenty of options for the emerging world.
Emerging market nations first began issuing debt denominated in U.S. dollars, which was done as a hedge. The general idea was that the greenback would be a reliable protection if an issuing country began to falter; the dollar would hold it up. With $3.5 billion in assets, the iShares JPMorgan USD Emerging Markets Bond (ARCA:EMB) is largest and oldest fund in the sector. The exchange-traded fund (ETF) currently tracks 107 different emerging market bonds and currently has a 12 month yield of 4.9%. Slightly smaller, but higher yielding, the PowerShares Emerging Sovereign Debt (ARCA:PCY) makes an ideal choice as well.
With the dollar predicted to continue its decline, local currency emerging market debt has exploded in popularity with investors. The Market Vectors Emerging Markets Local Currency Bond (ARCA:EMLC) and the actively managed WisdomTree Emerging Markets Local Debt (ARCA:ELD) will also provide capital gains and generous 5-7% dividends to investors in the sector.
Finally, analysts predict that emerging Asia could show the best prospects in the emerging market bond arena. The WisdomTree Asia Local Debt ETF (ARCA:ALD) could be the easiest way to add a wide swath of Asian bonds to a portfolio. The fund spreads its $400 million in assets into bonds from fast growing nations like Malaysia, Thailand and Singapore.
The Bottom Line
With the various debt problems facing the developed world, the risk premium for emerging market bonds is eroding. Their strong fiscal conservatism makes them an ideal candidate for a fixed income portfolio. The previous ETFs, along with the Market Vectors LatAm Aggregate Bond ETF (ARCA:BONO) make interesting plays. (For related reading, see An Inside Look At ETF Construction.)
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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.