Emerging Market Bonds: Good Bet or Bad?

Jennifer Yousif

Fixed Income Analyst

This week’s reader question is on fixed-income investments in developing countries: 

What is your thinking on emerging market bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates.? Is now the time to invest?

Emerging market bonds can add diversification and increase the yieldYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price. in your portfolio. The downside is that the higher yield comes with additional risk—though not as much as in years past. In fact, some large emerging market countries, such as Mexico, China and South Korea, hold investment-grade ratings.

That said, risksThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. still exist.

The recent hubbub surrounding Chinese real estate giant Evergrande is Exhibit A. A month ago, the company dominated the news cycle after it missed an interest payment to offshore bondholders. Since then, other Chinese land developers, including Modern Land and Fantasia Holdings, have had similar difficulties meeting their debt obligations.

That sounds ominous—largely because it’s reminiscent of the mortgage-related bonds at the center of the 2007–2008 global financial crisis—but we think the fear of contagion (problems spreading to other areas of the market) is overblown. The challenges facing Chinese property developers have been building for years: Evergrande’s stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. was down over 70% even before their default made headlines, and their debt is not tied into the global system the same way U.S. mortgage-backed bonds were back in the day. Oh, and Evergrande has actually managed to make a few of its payments more recently.

In other words, investors selling all emerging market bonds are throwing the baby out with the bathwater.

Right now, emerging market debt offers investors a yield premium of about three percentage points above U.S. Treasurys. We’ve seen it offer more than that (and less), but today’s level is fair by recent historical standards. Within our diversified fixed-income portfolios, we don’t currently own any funds that buy only emerging market bonds—we’d be more inclined to establish such a position when the risk-return dynamics look more favorable. However, the managers of the diversified bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. funds we buy for clients have the flexibility to buy emerging market bonds in moderation. And they will use it.

We think this makes good sense, as emerging market debt is ripe for active management. There are 30 or so emerging market economies, each with different characteristics. That’s a vast pond for an active manager to traverse in search of the best opportunities.

For more on bonds check out our Q4 Bond Outlook.

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