Emerging market bonds

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Emerging market debt has a long history in the international debt markets, going back to the early nineteenth century. Beginning in 1993, contemporary U.S investors have had access to the emerging market bond sector through the medium of mutual funds. Historically, most emerging market debt was in the form of external sovereign debt, denominated in an external currency (dollar, pound, euro). Today a majority (3/4) of emerging market debt is issued in local currency. [1] Thus investors have access to funds holding bonds in U.S dollars; funds holding bonds in local currencies; and funds that hold both. Emerging market bond mutual funds are actively managed. Recently the ETF marketplace has offered investors indexed portfolios of emerging market bonds.


Emerging market debt.jpg

Returns and risks

Prior to the Mexican default in the early 1980's, most sovereign emerging market debt was a product of bank financing. The establishment of so-called "Brady bonds"[2] during the ensuing Mexican debt restructuring transferred emerging market debt to the public bond markets. The data history of emerging market bond investment is therefore brief. Available data begins in 1991 with the creation of the JP Morgan EMBI index, [3] an index of U.S. dollar emerging market bonds.

As Erb, Harvey, and Visconti [4] noted in 1997, emerging market bond returns from 1991-1997 outperformed the performance of the S&P 500 index. They also noted that this short initial return sequence showed high volatility and negative skewness, suggesting that downside risk was high, although not realized in the short term returns data. This insight was proved correct, as the "Asian Contagion" financial crisis in 1998 produced negative returns in 1998. Returns from 2000-2010 have been somewhat less volatile (as measured by standard deviation, see table below), but the asset class has retained its quality of negative skewness. Erb, Harvey, and Visconti state:

One difficulty with measuring skewness is that it likely changes through time. Therefore looking at past data may give no indication of future expected skewness. This is the so called “peso problem” in economic theory. Looking at past currency movements, you may see little variation in rates during a managed float regime. However, there is a probability of a devaluation that you cannot detect from looking at past data. This is just the definition of negative skewness.

Emerging market bonds are subject to three major risks:

  • Interest rate risk. Most emerging market bond portfolios hold intermediate to long term bonds. Thus the portfolios have high durations and high interest rate risk: bond principal will fluctuate with changes in interest rates.
  • Currency risk. The marketplace is now dominated by local currency bond issues. These bonds bear currency risk, the risk that changes in exchange rates can result in gains or losses.
  • Sovereign risk. The risk that a country will default on its external non-local currency debt. Closely associated with this risk is inflation risk affecting local currency bonds, where a bond's principal value can effectively be destroyed by high inflation.

Table 1. Emerging Market bond index returns [5]


(View Google Spreadsheet in browser, then File --> Download as to download the file.)


Yields

Emerging market bond yields.jpg

In accordance with the high historical risks associated with emerging market bonds, investors have historically demanded high yields as compensation for bearing risk. Yields, of course, fluctuate with economic fundamentals, as well as with investor sentiment. Emerging market bond interest rates are often measured against risk free debt instruments, resulting in what is known as a "yield spread". The adjacent figure shows yield spreads for the period 1993-2010 between the US dollar denominated JP Morgan EMBI Index and comparable US treasury bonds. The figure also traces the level of credit quality within the EMBI index.

Correlation

The Vanguard Institutional white paper, Global fixed income: Considerations for U.S. investors, provides correlation data between emerging market bonds and major asset classes for the period between 2002-2010. Over this period, dollar based emerging market debt had higher correlations (between 0.55 and 0.65) with US stocks, developed market stocks, and emerging market stocks, as well as with US bonds; and lower correlations (between 0.30 and 0.45) with hedged and unhedged international bonds. Local currency bonds had lower correlations (0.30) with US stocks, developed market stocks, and emerging market stocks; and higher correlations (between 0.45 and 0.60) with US bonds, hedged international bonds, and unhedged international bonds. [6]

Erb, Harvey and Visconti note that emerging market bond correlations with other asset classes are subject to shifts, depending on the state of the economy and markets. Thus during the 1998 "Asian Contagion" currency crisis, emerging market bonds were highly correlated with US stocks, emerging market stocks, and high yield bonds, all of which fell in price, and were negatively correlated with US treasuries, which rose in price. [7]

Default risk

Bond defaults and restructurings have a long history. Prior to the nineteenth century, defaults were common among European nation states. With national independence movements beginning in the early nineteenth century and continuing to this day, bond defaults and restructurings became prevalent among these new "emerging markets."

Defaults and restructurings tend to occur in clusters. Historical clusters include: [8]

  • 1824-1834
  • 1867-1882
  • 1890-1900
  • 1911-1921
  • 1931-1940
  • 1976-1989
  • 1998-2004

The following table, based on the Reinhart, Rogoff, and Sevastano paper, Debt intolerance, provides historical default and restructuring data (1824-2001). The table also shows the amount of time countries have spent under default or restructuring, which has often been considerable. Reinhart, Rogoff, and Sevastano also note that defaulting nations have also frequently been high inflation nations, having experienced inflation at or above 40% per month.

Table 2. External Debt Defaults and Country Risk: 1824-2001 [9]
Country Defaults
or Restructurings
Percent of Years
in state of Default
or Restructurings
Argentina 4 26.1%
Brazil 7 25.6%
Chile 3 23.3%
Columbia 7 38.6%
Egypt 4 12.5%
Mexico 8 46.9%
Philippines 1 18.5%
Turkey 6 16.5%
Venezuela 9 38.6%
Group average 5.2 27.4%

The following table, drawn from the Vanguard Institutional paper, What's Next for the Eurozone and based on data supplied by Moody's, lists emerging market defaults and principal losses over the 1998 - 2006 period.

Table 3. Recent Debt Defaults : 1998-2006 [10]
Country Year Loss of Principal
Russia 1998 -82%
Ecuador 1999 -56%
Pakistan 1999 -48%
Ivory Coast 2000 -82%
Ukraine 2000 -31%
Argentina 2001 -73%
Moldova 2002 -40%
Uruguay 2003 -34%
Grenada 2004 -35%
Dominican Republic 2005 -5%
Belize 2006 -24%
Value weighted average - -45%

Arguments for holding emerging market bond funds

In the Vanguard Institutional white paper, Global fixed income: Considerations for U.S. investors, conditional recommendation for the emerging market bond asset class is enlisted in two main instances:

  1. Investors seeking total market international bond exposure. The Barclays Aggregate Global Bond Indexes do not include emerging market bonds.
  2. Potential for added diversification. The return properties of emerging market bonds: higher expected returns, higher volatility, and expected low correlations to other asset classes, may appeal to certain investors who wish to include it as a portion of a broadly diversified international bond investment.

In the first edition (2006) of author Rick Ferri's book, All About Asset Allocation, the author included emerging market bonds as a potential portion of a widely diversified taxable bond allocation. The author suggested the following allocation: [11]

Table 4. Fixed Income Allocation (Ferri 2006)
Fixed Income Allocation Fixed Income Category
50% Lehman Aggregate Bond Index
20% Treasury Inflation-Protected Bonds or I bonds
10% High Yield Corporate Bonds
10% Emerging Market Debt

In the second edition of All About Asset Allocation (2010), Ferri no longer includes emerging market bonds in his fixed income allocations, citing the high costs (0.50% to over 1.00%) incurred in implementing emerging market bond portfolios.[12]

Arguments against holding emerging market bond funds

Larry Swedroe et al., in their book, The Only Guide You'll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments [13] argue against including emerging market bonds in investment portfolios. The authors cite the higher default risk and extreme volatility associated with emerging market bonds as negative features of this asset. They make the following clarifying arguments about the negative features:

  • They are illiquid.[14]
  • There is the potential for large losses. They exhibit negative skewness and high kurtosis.
  • While having low correlation to other asset classes, the correlation of risk to equities tends to turn high at the wrong time: when equities are in distress and investors look to their bond portfolios to provide stability.
  • Returns are earned in a tax inefficient manner.
  • Implementation costs are high. Mutual funds are needed and they are expensive. [15]

The authors advise seeking emerging market exposure by investing in emerging market stocks; and state that emerging market bonds should be considered an allocation to the equity asset class (i.e. drawn from the portfolio allocation to equities, and not the portfolio allocation to bonds).[16]

Index funds and ETFs

As of 2013, the only indexed mutual fund portfolio of emerging market bonds available to U.S. investors is the Vanguard Emerging Markets Government Bond Index Fund tracking the Barclays USD EmergMkt GovRIC Cap Index. All other available options are ETF portfolios. Five broad market ETF's, all introduced within the past four years, are included in the table below. Three ETF portfolios, the iShares JPMorgan USD Emerging Markets Bond Fund; the PowerShares Emerging Markets Sovereign Debt Portfolio ETF, and the Vanguard Emerging Markets Government Bond ETF invest in U.S dollar denominated securities. The ishares and Powershare funds hold less than 100 bonds; the Vanguard ETF is expected to hold over 500 bonds. Two of the ETFs listed below, Market Vectors Emerging Markets Local Currency Bond ETF and the SPDR Barclays Capital Emerging Markets Local Bond ETF, invest in local currency bonds. These two ETFs hold between 100-500 bonds. All five ETFs invest in a wide number of emerging market countries, which is prudent, given the long history of sovereign default risk among emerging market countries. To further diversify against default risk, investors would also be well advised to make sure that the portfolios are not concentrated among a small selection of countries.

The ETF's have lower expense ratios than emerging market bond mutual funds or closed end funds, although ETF transaction costs (commissions, spreads, discount/premium) can significantly add to investment costs.

Table 5. International Emerging Market Bond ETFs
ETF Ticker Tracking index Expense ratio Hedging
iShares JPMorgan USD Emerging Markets Bond Fund [17] EMB JPMorgan EMBI Global Core Index 0.60% Dollar-based
Market Vectors Emerging Markets Local Currency Bond ETF [18] EMLC J.P. Morgan GBI-EMG Core Index 0.49% Unhedged
PowerShares Emerging Markets Sovereign Debt Portfolio ETF [19] PCY Deutsche Bank Emerging Market U.S. Dollar Balanced Liquid Index 0.50% Dollar-based
SPDR Barclays Capital Emerging Markets Local Bond ETF [20] EBND Barclays Capital EM Local Currency Government Diversified Index 0.50% Unhedged
Vanguard Emerging Markets Government Bond Index Fund (admiral) VGAVX Barclays USD EmergMkt GovRIC Cap Index 0.35% ; 0.75% purchase fee Dollar-based
Vanguard Emerging Markets Government Bond Index ETF VWOB Barclays USD EmergMkt GovRIC Cap Index 0.35% Dollar-based

Active funds and closed end funds

There are a large assortment of actively managed emerging market bond funds. [21] Most of these funds are load funds. No-load funds are available at lower costs with the lowest cost funds registering expense ratios running between 0.88% and 0.99% per annum.

Emerging market bond funds are also available as closed-end funds. These funds are traded on stock exchanges, often trade at discount or premium to net asset value, often employ leverage, and often utilize managed distribution policies. Most have higher than average expense ratios.

Active funds add to the risks inherent in emerging market bonds by introducing manager risk, the chance that poor security selection or focus on securities in a particular sector or category will cause the fund to underperform relevant benchmarks or other funds with a similar investment objective.

See also

References

  1. Bond Markets Defined, investinginbondseurope.
  2. Named after the Brady Plan, the principles of which were first articulated by U.S. Treasury Secretary Nicholas F. Brady in March 1989.
  3. Refer to FT Lexicon for a succinct description of JP Morgan emerging market bond indexes.
  4. Erb, Claude B., Harvey, Campbell R., and Viscanta, Tadas E., Understanding Emerging Market Bonds, Oct. 21, 1999.
  5. Data Sources: Returns for the Barclays US Emerging Markets Bond Index and the Barclays Global Emerging Markets Bond Index come from Factsheets and Guides. Returns for the JP Morgan EMBI Global Core index come from ishares. Returns for the JP Morgan EMBI Global index come from Fidelity Q2 Market Update. Returns for the DB Emerging Market U.S. Dollar Balanced Liquid index come from the prospectus reports of the PowerShares Emerging Markets Sovereign Debt Portfolio ETF , accessed through SEC EDGAR. Returns for the JP Morgan EMBI+ and ELMI+ Indexes come from Lazard Periodic Table of Fixed Income Indexes
  6. Davis, Joseph H. Ph.D., Patterson, Andrew J.; Philips, Christopher B. CFA, and Thomas, Charles J., Global fixed income: Considerations for U.S. investors, Vanguard Research and Commentary, January 2011, p.11.
  7. Erb, Claude B., Harvey, Campbell R., and Viscanta, Tadas E., Understanding Emerging Market Bonds, Oct. 21, 1999.
  8. Sovereign Defaults and Debt Restructurings:Historical Overview, Chapter 1, p 9.
  9. Reinhart, Carmen, Rogoff, Kenneth and Savastano, Miguel, Debt intolerance, Munich Personal RePEc Archive, working paper March 2003.
  10. Moody's Global Credit Research,Sovereign Default and Recovery Rates, 1983-2007,March 2008, and Lemco, Jonathan, Roger Aliaga-Díaz, and Charles J. Thomas, What’s Next for the Eurozone?, 2010.
  11. Rick Ferri, All About Asset Allocation, (2006), p. 149. As emerging market bond index funds were not available at the time, Ferri recommended two actively managed funds (from Fidelity and Payden) for allocation.
  12. Rick Ferri, All About Asset Allocation (2010)
  13. The Only Guide You'll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments
  14. A security that cannot easily be sold or exchanged for cash without a substantial loss in value. illiquid, from Investopedia
  15. The Only Guide You'll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments, pp.52-53.
  16. See Is Larry Swedroe saying NOT to own Emerging Markets? for a discussion regarding ownership of EM stocks.
  17. iShares JPMorgan USD Emerging Markets Bond Fund. The fund holds bonds from Argentina, Brazil, Bulgaria, Chile, China, Colombia, Ecuador, Egypt, El Salvador, Hungary, Indonesia, Iraq, Lebanon, Malaysia, Mexico, Panama, Peru, Philippines, Poland, Russia, Serbia, South Africa, Turkey, Ukraine, Uruguay and Venezuela.
  18. Market Vectors Emerging Markets Local Currency Bond ETF. The fund holds bonds from 17 countries.
  19. PowerShares Emerging Markets Sovereign Debt Portfolio ETF. The fund holds bonds from approximately 22 countries: Bulgaria, Brazil, Columbia, El Salvador, Hungary, Indonesia, Korea, Lithuania, Mexico, Panama, Peru, Philippines, Pakistan, Poland, Qatar, Russia, South Africa, Turkey, Ukraine, Uruguay, Vietnam and Venezuela.
  20. SPDR Barclays Capital Emerging Markets Local Bond ETF. The fund invests in bonds from Brazil, Chile, Colombia, Czech Republic, Egypt, Hungary, Indonesia, Israel, Malaysia, Mexico, Peru, Philippines, Poland, Russia, South Africa, South Korea, Thailand and Turkey
  21. See Morningstar for active emerging market bond funds.

External links

Bibliography