Emerging Market Bonds: Risk & Reward

For many investors, emerging market equities are seen as a long-term growth element for a portfolio. As these nations grow, investors have the ability to tap into their stories. But in order to grow, just like here at home, it takes plenty of capital. And as such, the world of emerging market bonds has grown.

As the name suggests, emerging market bonds are those issued by developing nations either on a corporate level or government level. These bonds are issued by nations all over the world, and investors can buy bonds from Asia, Latin America, Eastern Europe, Africa and the Middle East. And just like bonds from the U.S. government or PepsiCo, emerging market bonds feature credit ratings all the way from investment grade down to speculative junk.

All in all, according to the Bank of International Settlement, more than 25% of total outstanding global debt has been issued by emerging market entities. Investors should take notice of that fact.

For one thing, emerging market bonds often have higher yields than comparable issued and rated debt here at home. That’s due to the extra risk investors are taking on when owning an EM bond. For example, the additional yield an EM bond has over a Treasury is often in the 2 to 4% range.

Secondly, EM bonds have an inflation-fighting ability. Many developing nations are big commodity producers. With that, their economic growth is tied to the production of materials. As prices for these assets increase, so does the ability to repay their debts and reduces overall default risk. Historically, periods of reflation have been beneficial to EM bond prices.

In addition to the higher yields and an inflation-fighting ability, currency diversification plays a big part in the emerging market bond experience. With that, we have so-called Brady bonds and local currency-issued debt.

Back in the 1980s, Treasury Secretary Nicholas Brady launched a program to help developing nations finance their growth. This allowed EMs to issue bonds denominated in U.S. dollars. With the program, emerging market bonds became an asset class that institutions and international investors could finally trust and own.

At the same time, the strength and democratization of the global financial system have allowed more nations to issue debt in their respective currencies. Dubbed local-currency bonds, the vast bulk of issues today are done in rands, yuans, rupees and other developing market currencies.

The differences between the two and forex fluctuations can add an additional diversification benefit to a portfolio. For example, when it comes to USD-denominated Brady bonds, a rise in the dollar makes it more expensive for the issuer to service the debt. This tends to drop prices for these bonds. However, local currency issuers aren’t concerned with dollar prices from a payback standpoint. Conversely, if the dollar falls and the value of local currencies rises, local-currency bonds may offer a higher total return when translated back into dollars.

All in all, the song and dance between the dollar, local currencies and their interactions with each other creates a different set of diversification benefits and risks.

Given the differences offered by and potential benefits of using emerging market bonds in a portfolio, investors may want to consider them for a portfolio of their fixed income sleeve as some “spice” element. Given the complexities, buying an individual EM bond is pretty much impossible. However, there are numerous funds that own them.

For example, both the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) and Vanguard Emerging Markets Government Bond ETF (VWOB) offer exposure to USD-dominated EM bonds. Both funds feature low costs, large asset bases and plenty of trading volume. Additionally, they offer yields in excess of 6%.

But there are other choices as well. For example, the SPDR Bloomberg Emerging Markets Local Bond ETF (EBND) allows investors to tap into local currency bonds, while the VanEck Emerging Markets High Yield Bond ETF (HYEM) lets investors bet on junk-issued EM bonds.

Ultimately, buying a few different ETFs in the sector will allow an investor to gain exposure across all EM bonds. However, simply getting your feet wet with one fund could add additional yield and diversification to a portfolio.

Emerging market bonds offer a unique asset class for fixed income investors. Providing a series of benefits and different risks, they can add some spice to a portfolio and additional income. They are risky; however, for just a portion of a portfolio, the rewards may very well outweigh the risks.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.