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It
wasn’t that long ago when the mere mention
of emerging market bonds would send shivers down an investor’s spine. It was
not at all unusual to view this whole asset class as toxic. Today, it is one of
the hottest fixed-income investment areas. The fortunes of many investment
sectors are cyclical and for the past few years, the cycle has been incredibly
rewarding to investors in emerging-market bonds. Will this once peripheral
asset class continue to be a nice addition to an investor’s portfolio or
are they destined to become a poison once again.
Exactly What Are Emerging Market Bonds?
Emerging market bonds are the sovereign (government)
debt of emerging market countries – like Treasury bonds are here in the U.S. So
what makes a country an “emerging market?”
The International Monetary Fund (the IMF) originally
introduced the phrase “emerging market economy” in the early 1980s to describe
an economy with low per capita income. Mohamed El-Erian, who worked at the IMF,
and now heads the emerging markets group for PIMCO and manages their emerging
market debt fund, describes an emerging market economy as one with less than
$10,000 in annual per capita income.
The “emerging” part comes from the fact that these
economies are in the process of becoming more open and transparent to the rest
of the world. The motivation for this transformation is to attract the foreign
capital investment needed to foster their economic advancement.
Because these economies are less mature and less
stable than our own, emerging market bonds typically trade with a (yield)
“spread” relative to U.S. Treasury bonds. That is to say that investors demand
a higher yield (or yield premium) over Treasuries for investing in any debt
that has more perceived risk. The greater the perceived additional risk, the
greater (wider) the spread between the yield on that debt and treasuries.
Favorable Winds Have Been Blowing
The spread between any bond and treasuries will
widen or tighten as events unfold that affect the “health” of the bond’s
issuer. Over the past few years, several factors have combined to narrow the
spread versus Treasuries significantly (see chart below).
Because these economies are emerging, their
potential for growth is greater than more mature countries. And historically
low global interest rates, such as we have seen in recent years, provide the
ideal environment for emerging market countries to realize their greater growth
potential. First and most obvious, low rates allow them to finance their growth
more cheaply. But in addition, low rates around the world make the extra yield
available on emerging market bonds very attractive to yield-hungry investors
therefore making it easier for emerging market countries to get access to
credit.Indeed, the growth rates of emerging market countries have far outpaced those in the
developed world over the past several years. For example, Russia's economy surged 6% last year, marking six straight years of
better than 4% growth. While the U.S. has been racking up deficits, Russia actually
became a creditor nation by the end of 2004. They have been buying U.S.
Treasuries!
Russia, like a number of other emerging market
countries, is an oil exporter and the surging price of oil has been yet another
boost to their fortunes. Over the past five years, the average price of oil was
$31 a barrel. Over the past five months, a barrel of oil has averaged $48 and currently is above $55.
This
robust economic health has resulted in a slew of credit upgrades by the major
rating services. Moody's Investors Service has announced 50 sovereign upgrades
since the beginning of 2002 and only 17 downgrades. And when a bond’s credit
rating is upgraded, the perceived risk is less, which narrows the spread.
Further
contributing to the narrowing in spreads has been the decline in the U.S.
dollar. A falling dollar makes the interest earned (and any capital
appreciation as well) on a foreign bond worth more to U.S. investors, reducing
the effective yield premium needed.
This narrowing of the yield spread has translated
into strong returns for emerging market debt (bond prices move in the opposite
direction of yields). The Lehman Brothers U.S. Dollar Denominated Emerging
Market Bond Index hasn’t had a down year since 1998 (see table below). From
1999, when the current winning streak began, through 2004, the index is up 126%
compared to a 43.7% return for the investment grade Lehman Aggregate Bond Index
(a broad measure of both government and corporate bonds in the U.S.) and just
7.8% for the S&P 500.
| Lehman
Emerging Mrkt Bond Index Performance
(YTD 3/17/05) |
|
1994 |
1995 |
1996 |
1997 |
1998 |
1999 |
| Emerging Market Bonds |
-13.7 |
23.2 |
28.3 |
13.2 |
-11.6 |
23.1 |
| General U.S. Bond Mkt |
-2.9 |
18.5 |
3.6 |
9.7 |
8.7 |
-0.8 |
| S&P 500 |
1.3 |
37.6 |
23.0 |
33.4 |
28.6 |
21.0 |
|
2000 |
2001 |
2002 |
2003 |
2004 |
2005 |
| Emerging Market Bonds |
13.7 |
1.4 |
12.3 |
26.9 |
11.9 |
0.4 |
| General U.S. Bond Mkt |
11.6 |
8.4 |
10.3 |
4.1 |
4.3 |
-0.3 |
| S&P 500 |
-9.1 |
-11.9 |
-22.1 |
28.7 |
10.9 |
-1.3 |
Recent History Masks True Risk Picture
Despite their strong returns and improving fortunes,
don’t be lulled into a false sense of security when it comes to emerging market
bonds -- these are still risky securities.
While narrowing spreads over the past several years
have rewarded investors with higher prices, the flip side is that, going
forward, you are now getting a lot less “protection” (in the form of a higher
yield) in case something goes wrong.
And things do go wrong. Argentina recently defaulted
on some $100 billion of their debt. The Argentine Central Bank is coordinating
a “debt swap” that will pay holders of those bonds just 25¢ on the dollar.
While Russia is the “poster boy” for emerging market
health today – six years ago it was in default!
Even though there have been big improvements in the
quality of emerging market debt (Russia and several other countries are now
actually rated as investment grade or “BBB”) the average rating of the bonds in
the Lehman emerging market bond index is “B-” or speculative grade.
A Watchful Outlook
So far this year (through March 17) emerging market
bonds are still outpacing general U.S. bonds and stocks.
However, while the favorable winds that have been at
the backs of emerging markets may still be blowing, the wind speed is
decreasing. In fact, after a strong start, emerging market bonds have given back almost all of their gains (largely on fears of higher interest rates - more on that below) and are now up just 0.4% for the year.
Oil prices are likely to remain high -- particularly
relative to five years ago – and will continue to be beneficial to oil
exporters with the emerging markets. But we are unlikely to see a similar sharp
run up over the next five years.
Even without the salutary effects of higher oil
prices, emerging markets still offer the best growth prospects. And the
relatively low yield world we are in is likely to persist at least relative to
historical norms. Yield-hungry investors have few options to turn to as more
traditional fixed income areas have only a limited amount of appeal.
The risk to all this is that interest rates rise
faster and farther than expected. The flip side of the oil boom is the
potential for increased inflation. So far inflation remains muted and the
Federal Reserve has modestly increased short-term rates without any impact on
longer term rates. However, the more traditional relationship is for long rates
to increase along with short rates. The Fed has made it clear they expect to
continue increasing short rates; it is less clear that long rates will continue
to be unaffected.
The dollar’s effect on emerging market debt is
similarly a bit muddy. While longer-term forces (primarily our budget and trade
deficits) would seem to favor a continuation of a decline in the dollar’s
value, the short-term could see a stronger greenback. So far this year the
dollar has strengthened a bit versus most major currencies.
In addition, as we noted earlier, investment sector
returns are cyclical, and the fact that emerging market bonds have been on such
an extended roll should at the very least make investors watchful for signs of
trouble. In 1998, the year before their current streak began, emerging market
bonds (as measured by the Lehman index) fell 11.6% compared to a gain of 8.7% for the
Lehman Aggregate and 28.6% for the S&P 500.
In summary, recent stellar returns in emerging
market bond funds are not likely to be duplicated, but they still look
attractive relative to alternative fixed income asset classes. However, the
margin of safety is now much less and investors should not forget the risks
that these securities entail.
Our Exposure To Emerging Market Bonds
Currently we do not have a dedicated exposure to
emerging market debt in our portfolios through a “pure” emerging market bond fund.
However, we do have indirect exposure to this area in some of our portfolios
through multi-sector funds that invest a portion of their assets in emerging
market bonds, such as Loomis Sayles Bond, Fidelity Strategic Income and PIMCO All Asset.
These funds offer a “smoother ride” than a pure emerging markets fund, thanks to their
diversification across several sectors. In addition, we also benefit from the
experience and skill of these outstanding managers who can adjust their
exposure to emerging markets depending on their evaluation of the relative
risks and rewards. 
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