When we initiated positions in
emerging sovereign bond markets in late 2008, we were relatively early in
embracing the asset class as a core holding within portfolios. At the time,
many investors saw emerging markets debt, or EMD, as a niche asset class. Yet
our research indicated that it had changed dramatically over the previous
decade. More emerging countries were allowing their currencies to trade freely
in the market rather than pegging them to the US dollar. Their economies had
become more competitive, corporate governance had improved, and emerging nations
were generally more politically and socially stable than they had been a decade
earlier. Importantly, many had successfully addressed longstanding structural
issues over the previous decade. Public (i.e. government) balance sheets had
improved dramatically. In many instances, government budget deficits and
government debt as a percentage of GDP were now smaller than in many developed
nations. Not only that, but emerging economies held greater growth potential
than developed economies, making it very likely that growth in public revenue
would rather easily cover their governments’ fiscal obligations. In short, we
were able to buy debt supported by strong balance sheets with very attractive
yields.
Emerging sovereign debt markets
performed exceptionally well over the following four years with the exception
of a modest loss in local currency denominated bonds in 2011. From 2009 through
2012, emerging sovereign bond markets posted double-digit annualized returns. Emerging
markets bonds denominated in the currencies of their issuers, as measured by
the JP Morgan GBI-EM Global Diversified Index, provided equity-like returns
with significantly less volatility while those denominated in US Dollars, as
measured by the JP Morgan EMBI Global Diversified Index, fared better yet,
producing better returns than US and developed equity markets while incurring
dramatically lower volatility (Dollar-denominated debt is typically less
volatile than its local currency-denominated counterpart because it lacks the
volatility associated with currency fluctuations) (Table
1). The strong returns coupled with lower volatility resulted in better
risk-adjusted performance as measured by the Sharpe Ratio. Why is volatility
important? From a mathematical standpoint, lower volatility means more
efficient compounding of returns. If, on average, two investments have the same
expected return, lower volatility yields a higher compound rate of return (Table 2). While mathematics supports the case for a
lower volatility portfolio for a given return expectation, the proposition is
also emotionally appealing. Surely it’s easier to sleep at night with the first
portfolio than with the second or third. And you get paid more to rest easy.
Table 1: Performance 2009
- 2012
|
Annualized Return
|
Standard Deviation
|
Sharpe Ratio
|
EMBI Global Div Index
|
16.42
|
6.67
|
2.45
|
GBI-EM Global Div Index
|
12.80
|
12.96
|
0.98
|
MSCI EAFE
|
10.51
|
21.02
|
0.49
|
MSCI Emerging Mkt
|
19.97
|
24.22
|
0.82
|
S&P 500
|
14.58
|
16.96
|
0.85
|
Table 2
|
Year 1
|
Year 2
|
Year 3
|
Simple Average
|
Annualized Average
|
Portfolio 1
|
8%
|
8%
|
8%
|
8%
|
8.00%
|
Portfolio 2
|
8%
|
-8%
|
24%
|
8%
|
7.20%
|
Portfolio3
|
8%
|
-16%
|
36%
|
9.33%
|
7.25%
|
Of course, this year has been a very
different story as both stocks and bonds in emerging countries have declined
significantly. Investors have been concerned that the European recession, weak
growth in the US, and increased competition from Japan due to the rapid
devaluation of the Yen will crimp growth prospects for emerging economies. However,
we believe that the real driver behind this year’s performance in emerging
stock and bond markets has been concern that the Fed may reduce, or even end,
its quantitative easing program (i.e. bond buying program), resulting in the reversal
of carry trades. Carry trades involve borrowing in a currency where interest
rates are exceptionally low to take advantage of higher yielding investments
denominated in another currency. Also, US dollar-denominated emerging debt
trades at a spread (i.e. yield premium) to US Treasuries. As the concerns over
the Fed’s purchase program have pushed up Treasury yields, yields on emerging
US Dollar-denominated debt have also risen. Finally, global bond markets have
less liquidity than they did prior to the credit crisis due to legislation that
had altered the willingness of financial institutions to make markets in, and
hold inventory of, bonds across many asset classes. The result has been
somewhat of a perfect storm for emerging bond markets. The local currency denominated
benchmark, the JP Morgan GBI-EM Global Diversified Bond Index, is down 11.45%
year-to-date while the US Dollar-denominated benchmark, the JP Morgan EMBI
Global Diversified Bond Index, is down 9.03% year-to-date through August. The
loss in the former is largely due to currency depreciation against the US Dollar
with the benchmark down a far more modest 2.84% when measured in local currency.
The loss in the US Dollar denominated benchmark is due to rising Treasury
yields and the widening of spreads between US Treasuries and emerging
government bonds. As a result of these price declines, yields on both
benchmarks have risen to rather attractive levels for fixed income securities
rated, on average, at the low end of the investment grade spectrum (for the local
currency benchmark) and at the highest end of the high yield spectrum (for the
dollar-denominated index). The benchmarks yield multiple percentage points more
than the 10-year debt issued by similarly rated nations from the troubled
European periphery. Note that while the table below compares the yields on the
benchmark to the yields on benchmark 10-year bonds of the European periphery, the
average maturity of the two emerging markets benchmarks are less than 10-years (Table 3).
Table 3
|
S&P Ratings
|
S&P Ratings
|
|
Local Currency
|
Foreign Currency
|
Yield
|
|
Italy
|
BBB
|
BBB
|
4.51%
|
Spain
|
BBB-
|
BBB-
|
4.53%
|
Ireland
|
BBB+
|
BBB+
|
4.02%
|
Portugal
|
BB
|
BB
|
6.96%
|
Greece
|
B-
|
B-
|
10.46%
|
EMBI Global Div Index
|
NA
|
BB+
|
6.27%
|
GBI-EM Global Div Index
|
BBB+
|
NA
|
6.99%
|
As an asset class, the bonds of
emerging sovereign governments offer investors an opportunity to earn far
higher yields lending to countries with stronger growth prospects, and in many
instances, stronger balance sheets, than they can lending to overly indebted
developed countries with poor growth prospects. Global bond markets are likely
to remain volatile as investors parse every word from the Fed and assess what
any policy changes may mean for global markets. Emerging debt markets are
likely to remain volatile as the markets continue to evaluate potential and
actual changes in Federal Reserve Policy and the volatility may be exacerbated
by a the lower liquidity that has pervaded bond markets due to US legislative
changes. Yet the current weakness offers an opportunity for investors to
purchase assets with sound fundamentals and attractive yields at discounted
prices. Moreover, the recent gulf in performance between emerging bond markets
and developed equity markets suggests that their return potential over the
subsequent three to five years is likely similar to, or better than, US and
developed international equity markets. Coupled with the lower long-term volatility
profile of emerging bond markets relative equities, the asset class offers not
only attractive absolute returns, but very attractive risk-adjusted returns
over the long-term.