Emerging market bonds – the fixed income debt that is issued by countries with developing economies as well as by corporations within those nations – have become increasingly popular in investor portfolios in recent years. Their traction has been attributed to the bonds' rising credit quality and their higher yields, relative to U.S. corporate and Treasury bonds.

As is often the case in the investment world, however, higher returns often come with an increased level of risk, and emerging market issues do tend to carry higher risks than those associated with domestic debt instruments. In this article, we'll take a look at emerging market bonds and weigh the potential risks and rewards versus other fixed income asset classes.

Evolution of Emerging Market Bonds

Throughout most of the 20th century, countries with emerging economies issued bonds only intermittently. In the 1980s, however, then-Treasury Secretary Nicholas Brady began a program to help global economies restructure their debt via bond issues, mostly denominated in U.S. dollars. Many countries in Latin America issued these so-called Brady bonds throughout the next two decades, marking an upswing in the issuance of emerging market debt.

As the market for emerging debt began to grow and as additional foreign markets began to mature, developing countries began to issue bonds more frequently, both in U.S. dollar denominations  and in their own currency; the latter became known as "local market bonds." In addition, foreign corporations began issuing and selling bonds, giving a boost to the global corporate credit market.

Macroeconomic Sophistication Paves the Way

The expansion of emerging market bonds coincided with a growing sophistication of the macroeconomic policies on the part of these developing nations, such as the implementation of cohesive fiscal and monetary policies, which gave foreign investors confidence in these countries' long-term stability. As investors began to act upon the increased reliability of the economies of developing nations and the growing diversity of the bond issuances, emerging market bonds rose as a major fixed-income asset class.

Today, bonds are issued from developing nations and corporations all over the world, including Asia, Latin America, Eastern Europe, Africa, and the Middle East. The types of fixed income instruments, in addition to Brady bonds and local market bonds, include eurobonds and Yankee bonds. Emerging market debt is also offered in a wide array of derivatives as well as short and long duration bonds.

Risks of EM Bonds

The risks of investing in emerging market bonds include the standard risks that accompany all debt issues, such as the variables of the issuer's economic or financial performance and the ability of the issuer to meet payment obligations. These risks are heightened, however, due to the potential political and economic volatility of developing nations. Although emerging countries, overall, have taken great strides in limiting country risks or sovereign risk, it is undeniable that the chance of socioeconomic instability is more considerable in these nations than in developed countries, particularly the U.S.

Emerging markets also pose other cross-border risks, including exchange rate fluctuations and currency devaluations. If a bond is issued in local currency, the rate of the dollar versus that currency can positively or negatively affect your yield. When that local currency is strong compared to the dollar, your returns will be positively impacted, while a weak local currency adversely affects the exchange rate and negatively impacts the yield. If you do not want to partake in currency risk, however, it is possible to just invest in bonds that are dollar-denominated or issued only in U.S. dollars.

Emerging market debt risk is assessed by rating agencies that measure each developing nation's ability to meet its debt obligations. Standard & Poor's and Moody's ratings tend to be the most widely followed ratings agencies. Countries
that have a rating of 'BBB' (or 'Baa3') or higher are generally considered investment grade, meaning it is safe to assume the country will be able to make its
payments on time. However, lower ratings are indicative of speculative
grade investments, suggesting that the risk is relatively higher and
that the nation may not be able to meet its debt obligations.

Following Developing Markets

One investment instrument that can protect bondholders against the risk that developing sovereign nations or foreign companies will default is the credit default swap (CDS). CDSs have the ability to protect investors by guaranteeing the face value of the debt in exchange for the underlying securities, or their equivalent in cash if the nation or the corporation fails to honor the debt.

However, while credit default swaps protect investors from potential loss, a sharp increase in the credit default swaps market for a particular developing nation can often indicate a growing concern that the country (or corporations within that nation) may not be able to honor its debt. So, both lower agency ratings and a basis point rise in a nation's credit default swaps are considered red flags with regard to a particular emerging market and its ability to repay a debt to investors.

Advantages of Emerging Market Bonds

Despite these risks, emerging market bonds offer numerous potential rewards. Perhaps most significantly, they provide portfolio diversity, because their returns are not closely correlated to traditional asset classes. In addition, many investors who are looking to offset the currency risk present in the rest of their portfolios choose to invest in emerging market bonds issued in local currencies as a valuable tool in hedging this risk.

Then too, developing countries have a tendency to grow rapidly, which can often
enhance returns. For this reason, among others, yield returns of emerging debt have historically been higher than those of U.S. Treasuries.

Investors often track the yield of U.S. Treasuries versus emerging market bonds and look for a widening of the spread, or extra yield, that emerging market bonds can offer at any given time. The higher the basis point spread of this yield is (i.e., the higher the emerging market yield is relative to Treasuries), the more attractive emerging market bonds are relative to Treasuries as an investment vehicle and the more willing investors are to take on the other inherent risks of emerging market bonds.

How to Invest in EM Bonds

If you decide that the potential rewards offset the potential risks of investing in emerging market bonds, there are numerous options, although some limitations exist. When investing in emerging markets, in many cases it is not possible, or highly improbable, for an individual investor to invest directly in a developing country's bonds or debt issued by foreign corporations. Most U.S.-based mutual fund companies, however, have a variety of emerging market fixed income funds to choose from.

These funds have options of bond issuances from developing countries and corporations denominated in U.S. dollars and/or local currencies. Some funds invest in a diversified mix of emerging market bonds from all over the world while some focus on regions, such as Asia, Eastern Europe or Latin America. Additionally, some funds focus exclusively on government issues or corporate bonds, while some have a diversified combination.

Some funds track one of the many indexes that follow the performance of emerging market bonds, most notably the J.P. Morgan Emerging Markets Bond Index Global (EMBI Global) and the J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI). The EMBI Global covers debt issued from over 25 countries including China, Russia, South Africa, Brazil, and Poland, while the CEMBI follows corporate issues for approximately 80 bonds from more than 50 corporations in 15 nations.

The Bottom Line

Emerging markets have now become a fixture in the global fixed income investment universe. As developing countries continue to grow, the investment opportunities will only expand. While there are inherent risks associated with investing in developing economies, sufficient rewards may be available for discerning investors who take the time to educate themselves about emerging market bonds.