Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

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SimpleGift
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Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by SimpleGift »

In a recent thread, the idea was raised about using emerging market bonds as a substitute, either in part or whole, for one's portfolio allocation to emerging market stocks — and it's an intriguing enough option to deserve its own discussion. When one compares the growth charts of emerging market bond funds over the last 18 years with the emerging market stock index (chart below), it's apparent that EM bonds have provided much better returns than EM stocks, with much less volatility. Of course, future returns may vary.

Performance of Emerging Market Bonds vs. Emerging Market Stocks (in red), 1997-2015
Image
Note: The four EM bond funds shown have at least a 15-year history, plus Morningstar coverage.
Source: Morningstar

The outperformance of EM bonds over EM stocks is a bit surprising and puzzling. Perhaps the problem of rampant share dilution in EM stocks is much worse than imagined. At least with EM bonds, the borrower has an obligation to make the interest payments when due. As a result, it appears that EM bond holders have been able to reap the benefits of the strong economic growth in emerging markets without the volatility of EM stocks.

What do Bogleheads think about the idea of replacing, in part or whole, one's EM stock allocation with EM bonds? Any pitfalls to consider? Any EM bond funds or ETFs that you might recommend for this purpose?

PS. For those unfamiliar with the EM bond asset class, Morningstar recently published a brief review.
Last edited by SimpleGift on Sat Jun 27, 2015 8:08 pm, edited 3 times in total.
lack_ey
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by lack_ey »

EM bond funds are more expensive than EM stock funds, more so if getting into local currency or something more specialized. Vanguard's fund (USD issues) has an ER of 0.34%.

Current EM bond yields are kind of not that exciting. Again, Vanguard's fund has an SEC yield of 4.63%. After taking into account some defaults, credit upgrades/downgrades, yield curve rolldown, etc., I don't think you can expect anything much over 5% sustainably from this. If EM stocks can't even top that in the mid-long run, I'll be a sad panda. And that would beg the question of why anybody would invest in EM stocks and subject themselves to all that volatility.
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by asset_chaos »

bonds != stocks
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Maynard F. Speer
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by Maynard F. Speer »

Looking at Research Affiliates' data, EM stocks and bonds are estimated to produce similar 10-year returns, with both being mainly driven by yield and FX (so I don't think the idea's crazy)

Image

However, I'm pondering EM small-caps being the better way to invest in Emerging Markets going forwards, as that will give you more domestic market exposure, and of course much more in the consumer sector ... Could it be that EM Large-caps have been too reliant on the health of the developed world, with the added risk of investing in the developing world?

My best EM investments have been more focused - either sector or region-specific - with more small and mid-caps
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by dh »

Interesting. I do not think of EM Bonds as substitute for EM stock, I own both. EM Bonds (via Vanguard's emerging market bond, VGAVX, fund) are 8.7% of my fixed income portfolio, yet I don't think of that percentage as a replacement for emerging market stock holdings. Note. I do not own Vanguard's Emerging Market stock fund, emerging markets are 18.8% of the Total International fund I own.

It will be interesting to see if the pattern the OP identified continues.
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by nedsaid »

Oh no! Another "must have" asset class for investors. For an asset class junkie like me this is terrible news! I barely dipped my toe in International Real Estate and now I will be tempted to add Emerging Market Debt. I own the Templeton Global Bond Fund in a workplace savings plan and this has a bunch of EM Debt in it, but last I looked this fund is about 1% of my retirement portfolio. It would make sense to own both EM Stocks and EM Bonds but I haven't thought too much about the proper proportions in a portfolio.
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by Alvaro »

Can someone explain:

- the difference between local vs. non-local EM debt
- what is wrong with VWOB - it is the EM bond with the lowest MER, so other things being equal, it would be the first choice. But prior comments in this thread and elsewhere seem to imply that other things are not equal, and that VWOB is not the best way to go for EM debt exposure. Why not?
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by ANC »

From 2004-2014, I owned PREMX and the comparable stock fund (PRMSX) from the same provider. The stock outperformed slightly (by a little under 1% per year) but way outperformed in 2008 (-18% vs -60%). This is obviously an individual case, but it may point out active funds' ability to avoid some over-concentrations such as state-run companies. The bond fund is 32bp cheaper.

Many analysts say that EM bonds during this period benefited from credit upgrades that can not expect to be repeated, such as in Mexico.

One interesting note about PREMX is that it was overweight in Venezuela during this period, which despite its political rhetoric always paid its bills. So far, this has continued during the current economic troubles, but there is definitely a risk there:
http://www.reuters.com/article/2015/03/ ... HM20150317

Finally, note that the EM bond funds do include frontier markets that the EM stock funds generally stay away from. For example, PREMX includes Venezuela, Argentina, and Serbia in its top 10 countries, while PEBIX includes Colombia and Kazakhstan. This is consistent with Bill Bernstein's finding in "Birth of Plenty" that government bond markets develop long before stock and corporate bond markets in developing countries (including England and the US in their day).
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by in_reality »

Alvaro wrote:Can someone explain:

- the difference between local vs. non-local EM debt
local debt is denominated in the local currency. non-local is typically USD

So local EB debt also has additional currency risk. Then again, if a local currency weakened that much, a country might have trouble meeting payments on it's USD denominated debt and default.
Alvaro wrote: - what is wrong with VWOB - it is the EM bond with the lowest MER, so other things being equal, it would be the first choice. But prior comments in this thread and elsewhere seem to imply that other things are not equal, and that VWOB is not the best way to go for EM debt exposure. Why not?
Nothing really. dh above mentioned having 8.7% in it. [VGAVX is the admiral share class of VWOB so has the same ER]. Maybe some prefer local EM bonds or maybe some prefer not having corporates.
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by michaelsieg »

What strikes me is that the local EM debt and the non-local (US $ denominated) bonds have such a different expected return in the Research Affiliates graph that Maynard posted.
I find that difficult to explain.
I think the currency hedged funds like VGAVX probably should be counted to the local EM debt, as the currency hedging apparently costs only a few bp's (not sure exactly how much it was, but it was discussed here on the forum when this fund initially opened).
Simplegift, thanks for starting this interesting discussion.
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by SimpleGift »

Researching the source of returns for emerging market bonds, I ran across the chart below, which breaks down the relative contributions of income, capital appreciation and currency fluctuations to EM bond returns for the 2002-2014 period.

Income was by far the largest component of return, but capital appreciation was also quite significant, reflecting the falling interest rates during the period, plus the credit upgrades that poster ANC referenced upthread. Currency fluctuations were the main driver of volatility, but not long-term returns.

In short, it appears that EM bonds in recent years have benefited from two factors that are not likely to repeat themselves, namely steadily falling interest rates and credit upgrades, as the emerging countries "emerged." Without the contribution of these two return sources going forward, any expected excess returns from EM bonds would have to come from currency appreciation, which is a risky factor to predict. Thus, it seems very unlikely that EM bonds can continue their outperformance over EM stocks in the years to come — unless I'm missing something?
Last edited by SimpleGift on Sun Jun 28, 2015 9:04 am, edited 4 times in total.
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by Rx 4 investing »

Although my reading of the economic tea leaves suggests that the world is experiencing falling inflation, and sub-par growth, neither of which is ideal for EM bonds, nonetheless, we have allocations to both EM stocks and EM bonds in our retirement portfolio. They are however throwing off some pretty decent yields in this sub-atomic interest rate era.

--Our retirement portfolio is roughly 50% stocks / 45% bonds / 5% cash.

--Half (1/2) of the stock portion is international. Twenty two (22%) of the international allocation is in EM stocks, which is in line with Vanguard's portfolio watch for "stock markets outside US." We have several diversified international funds with portions in EM (two accounts outside of Vanguard) , but our largest holding is Vanguard Emerging Markets Stock Index Fund Admiral Shares (VEMAX).

--Twelve (12%) percent of the bond allocation is to international; this is split 50:50, i.e. half to Vanguard Emerging Markets Government Bond Index Fund Admiral Shares (VGAVX), and the half among a few other diversified international funds. Our international bonds are down from about 25% from a couple of years ago after the dramatic decline in international interest rates. On a "relative" basis, the US now has some of the highest interest rates in the world.

I used the following inputs as a "stake in the ground" for EM bond ranges.

--Jason Zweig's (WSJ) comments on EM bonds in The Intelligent Investor recommends limiting EM bonds to no more than 10% of a bond portfolio.

-- Seninvest.com's recommendation of 10% to international for an "aggressive" bond portfolio. He recommends 1/2 of the 10% to EM bonds, and 1/2 to diversified international bonds.

--Ray Dalio's /Bridgewater Associate's "All Weather" portfolio is roughly a 40% stocks / 60% bonds portfolio. At equal weightings of the sub-components that go into each of 4 boxes representing their different economic scenarios, EM debt is approximately 10% of his bonds allocation.
( Bridgewater believes EM debt fares well in both a rising global growth scenario, and in rising global inflation scenario. ).

Good luck to everyone in the months ahead! :happy
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by Robert T »

.
While the historical returns of EM bonds looks attractive, I personally wouldn’t equate bonds and stocks. For example, just because Vanguard Total Bond has beaten Vanguard Total Stock over the last 15 years to date (5.16 vs. 5.07 according to M*) doesn’t mean we should treat US bonds as a proxy for US stocks.

FWIW here are some historical returns of EM bonds, and EM stocks with varying tilts to value, quality, and momentum. While EM bond index returns have exceeded returns of the MSCI EM stock index over the last 16 years by 0.4% annualized, it has lagged series that were diversified across more ‘equity factors’.

Obviously no guarantees (and the first set are index returns, not live fund returns).

1999-2014: Annualized return/SD/Sharpe

..9.8/10.3/0.87 = JP Morgan Emerging Market Bond

MSCI EM Stock Indexes
..9.4/35.5/0.39 = Market
11.4/36.6/0.44 = Value weighted
11.8/34.2/0.46 = Quality
12.5/38.2/0.47 = Momentum
12.0/36.2/0.46 = 1/3 Value weighted: 1/3 Quality: 1/3 Momentum
13.6/42.4/0.47 = Diversified Multi-Factor

14.8/40.2/0.51 = RAFI EM

Live fund returns

..9.2/34.6/0.38 = Vanguard EM
11.9/42.1/0.43 = DFA EM Value
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Maynard F. Speer
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by Maynard F. Speer »

Simplegift wrote:In short, it appears that EM bonds in recent years have benefited from two factors that are not likely to repeat themselves, namely steadily falling interest rates and credit upgrades, as the emerging countries "emerged." Without the contribution of these two return sources going forward, any expected excess returns from EM bonds would have to come from currency appreciation, which is a risky factor to predict. Thus, it's difficult to see how EM bonds can continue to outperform EM stocks in the years to come — unless I'm missing something here?
That's how I'd see it, and it's in line with estimates I've got .. Bond valuations look likely to be a drag, only offset by yields, with currency being the main driver of returns going forwards

Then again, with developed world stock and bond valuations where they are, I notice many hedge funds holding EM notes and bonds (especially Mexican and Brazilian)

EM stocks probably make more sense to me longer-term - and valuations should be working in your favour ... I believe Barclays has just upped its EM stock exposure to 17% (from 10), believing the second half of the year will favour EM ... I'm not sure about that, but the only two places I can really find value right now are Eastern Europe and EM Small-Caps (for those with a strong stomach)
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by robert88 »

Maynard F. Speer wrote:Looking at Research Affiliates' data, EM stocks and bonds are estimated to produce similar 10-year returns, with both being mainly driven by yield and FX (so I don't think the idea's crazy)
They seem to think the ruble is way undervalued for some reason.
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by Maynard F. Speer »

robert88 wrote:
Maynard F. Speer wrote:Looking at Research Affiliates' data, EM stocks and bonds are estimated to produce similar 10-year returns, with both being mainly driven by yield and FX (so I don't think the idea's crazy)
They seem to think the ruble is way undervalued for some reason.
Oh yes .. Down 50% since 2013, and even Russians don't want to hold much wealth in their own currency (much more of a squeeze on their economy and the government could presumably start seizing financial assets)

I'm not even sure risk's adequately priced into Russia, but the rewards are certainly there if the international situation improves
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by garlandwhizzer »

Very interesting thread. A few things, not all, are clear for me. For most of us, EM bonds, whether denominated in dollars or local currency, do not belong in US based bond portfolios due to their instability during market and political crises which is the central reason we hold bonds. Second dollar hedging EM bonds reduces volatility but increases costs. Third currency swings can substantially impact EM local currency returns. The Russian Ruble, the Indian Rupee, and the Brazilian Real have all severely depreciated in value relative to the dollar in recent years while the Chinese Yuan has slightly appreciated. Currency swings can substantially impact local debt EM returns depending on which countries the bonds originate from. We are currently in period of relative dollar strength partly due to the market's anticipation of a divergence in monetary policy between the US (increasing expected economic growth and rising interest rates) and the rest of the developed world (depressed growth requiting QE and/or decreasing interest rates). It is hard to imagine that EM local debt will produce substantial returns to US investors against the headwinds of a strengthening dollar.

However many analysts looking at the long term picture in the future believe that at some point the increased debt relative to growth rate in the US will produce a secular countertrend relative to EM currencies whose countries in general have less debt and more growth. If that happens (unknown) it will add to returns of EM local debt as well as EM stocks returns, both of which are typically denominated in local currency, but it will not help EM debt denominated in dollars like the Vanguard EM bond fund. The optimistic projections on EM local debt by RA and others anticipates an optimistic outcome from currency relative to the dollar in addition to the fact that EM bond yields are significantly higher in local currency than US and DM yields.

Ultimately since most EM equity, especially small caps, are also denominated in local currency, those currency swings will impact EM equity returns as well. Hence the question of whether to put part of your EM equity exposure in EM bonds comes down not to currency but to whether you believe the future will be a continuation of bond bull market of recent decades. Robert T and Simplegift, both of whom are astute in my opinion, have made the point that the future of EM local debt may not be as rewarding relative to EM equity as the past has been. I do suspect however that EM local debt will be significantly less volatile in the future than EM equity. It might be an asset class to consider if you want to tap into EM potential but avoid the white knuckle roller coaster ride of EM equity. If we combine EM local debt yields (about 5%+ in local currency) with local currency appreciation and low volatility it might not be a bad place to park a modest percentage of the portfolio. I will keep an eye on the interesting asset class of EM local debt in the future of anticipated low returns but at present will stay the course exactly where I am.

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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by SimpleGift »

garlandwhizzer wrote:I do suspect however that EM local debt will be significantly less volatile in the future than EM equity. It might be an asset class to consider if you want to tap into EM potential but avoid the white knuckle roller coaster ride of EM equity.
When adding emerging market bonds to a portfolio, because of the hybrid nature of their risk and their higher correlation with both developed and emerging market stocks, investors may need to make an adjustment in their overall stock-bond allocation, to maintain the same overall risk profile. The question is how much adjustment?

In his book, All About Asset Allocation, in a discussion of high-yield bonds, Rick Ferri calculates that about 20% of the risk in BB-rated corporate high-yield debt and about 40% of the risk in CCC-rated bonds can be considered equity-related. Therefore he suggests that investors who add a 10% allocation of high-yield debt should consider about 2%-4% of this as part of their equity allocation, to maintain the same overall risk level.

I'd expect this same range of allocation adjustment might apply when adding emerging or frontier market bond funds.
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by gkaplan »

I did a cursory check of Vanguard's emerging markets bond fund yesterday. It seemed to me that most of the markets it invested in would be considered frontier markets, not emerging markets. I have a considerable allocation to the Vanguard Emerging Markets Stock Fund; however, I don't know if I have the stomach for Vanguard's emerging markets bond fund.
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by michaelsieg »

Just out of curiosity I did a cursory check of the 850 bond holdings in the fund (VGAVX) yesterday.
Vanguard didn't put any Greek government bonds in it, which at this point seems to be a good thing.
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by randomguy »

Do you expect interest rates to drop the same way the did from 1997-2015 AND for the premium between EM and developed country bonds also to drop? Both seem very unlikley. Looking at charts like this is the same as putting up the graph of US stocks from 1985-1999 and asking why own anything esle. It is easy to pick the winners in hindsight (i.e. emerging market bonds were the winners of the last 15 years). The winners of the last cycle are rarely the winners of the next one.
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by watchnerd »

michaelsieg wrote:Just out of curiosity I did a cursory check of the 850 bond holdings in the fund (VGAVX) yesterday.
Vanguard didn't put any Greek government bonds in it, which at this point seems to be a good thing.
While there has been talk of downgrading Greece from developed to emerging, as far as I know it's still considered developed in most indices, as by measures such as GDP/capita ($18k/capita nominal, $26k/capita PPP) it's still well above most emerging marketing economies (e.g. neighboring Turkey, ($10k/capita nominal, $19k/capital PPP).
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by michaelsieg »

as far as I know it's still considered developed in most indices
Thanks watchword - I hope for them they stay there
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Re: Emerging Market Bonds as a Portfolio Proxy for EM Stocks?

Post by AlohaJoe »

I came across this thread because I had the same questions Simplegift did at the start. I was reading Vanguard's 2013 paper on Emerging Markets bonds that had this chart

Image

This thread does a good job of giving some answers. Thanks for that! :)
Simplegift wrote:In short, it appears that EM bonds in recent years have benefited from two factors that are not likely to repeat themselves, namely steadily falling interest rates and credit upgrades, as the emerging countries "emerged." Without the contribution of these two return sources going forward, any expected excess returns from EM bonds would have to come from currency appreciation, which is a risky factor to predict. Thus, it seems very unlikely that EM bonds can continue their outperformance over EM stocks in the years to come — unless I'm missing something?
I don't disagree with your analysis but just to show hard it is to predict the future....since SImplegift made this comment....

Image

Another year where EM Bonds outperformed EM Stocks. :shock:
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