Although most emerging market countries no longer face the violent upheavals of the past, not everyo...
Although most emerging market countries no longer face the violent upheavals of the past, not everyone has yet realised this fact. Emerging market bond yields are therefore still compensating for diminishing threats, presenting investors with a real profit opportunity.
These are countries with improving fiscal discipline and balance sheets issuing bonds with very high yields. They are clearly credit-worthy nations, but out-of-date preconceptions are blocking wider appreciation of their bonds.
Emerging market sovereign bond yields of between 2-110% over US Treasury bonds are extremely high relative to any sober assessment of risk. The rewards are considerable, with yields of around 10% in a mainstream currency like the dollar.
The lower the credit quality and the higher the perceived risk, the higher the yield you enjoy as compensation. Historically, investors have been richly rewarded for lending to the less credit worthy, and the reward for investing in lower grade credits tends to overcompensate heavily for the risks.
The payments record on emerging market sovereign bonds has been impressive, with just 13 long-term public bond defaults by sovereign governments since the end of the Second World War. Default is far more common in the US high yield market.
As public sector capital shrinks for emerging market nations, governments increasingly need to maintain access to foreign private capital.
Sovereign debtors are understandably reluctant to brave the possibility of capital markets remaining closed to them if they were to default, or risk the tough sanctions bondholders can invoke in the event of the restructuring of defaulted debt. Foreign bond obligations tend to be sacrosanct as a result.
Emerging market bonds are less exposed to certain risks than the safer bonds of more developed nations.
While UK Government bond prices rise or fall in line with market interest rates changes, the greater counter-cyclicality of emerging market bonds tends to counteract the interest rate trends in developed markets.
Emerging market bonds are less vulnerable to a high oil price, for example, as many emerging market countries are commodity or oil exporters.
Consequently, their economies tend to benefit when commodity and oil prices are rising, normally when bonds in the more developed markets are weakening, as they price in concerns about inflation.
Emerging market bonds are also less vulnerable to erosion from interest rate rises than lower yielding bonds such as UK gilts.
Because of emerging market bonds' divergence from leading market trends, the asset class in itself provides significant diversification properties and therefore protection to investors. Funds investing in this area should be diversified by credit quality, ranging from BBB investment grade credits to CCC ratings, geographical regions, and a range of countries within those regions.
Of course you cannot ignore the risks. Credit risk measures the possibility of the security issuer defaulting or the bond's credit rating being reduced, which usually means the investment value will fall.
Historically, part of the attraction of bonds for British investors has been their safety: the Government is unlikely to renege on its bonds. Does that safety vanish once you start investing overseas? The answer depends on the emerging market nations, and bonds in which you invest.
There is a complex spectrum of international risk, from newly investment grade Mexican bonds to Caa3 rated Ecuadorian bonds. However, in this volatile yet high-return asset class, it takes a very skilled investor to decide on acceptable levels of risk and the appropriate yield you should be paid for taking on these risks.
In this respect, conventional credit analysis can fall short of expert in-depth research. With emerging markets, too many credit agencies and fund managers focus on broad debt measures and balance of payment indicators rather than looking at the structure of countries' debts and balance sheets, and the proportion of total debt represented by government to government and private sector debt.
Nigeria and Ecuador both have equally high levels of debt, for example, but Nigeria's debt is primarily government to government, which leaves it plenty of scope to issue bonds to private investors. The bulk of Ecuador's debt is in eurobonds, which means it is top-heavy in this sector and therefore more vulnerable.
You also have to analyse the actual type of bond on offer, using in-depth specialist research.
While Russia's Soviet era bonds have underperformed, its New Russian debt, from after the dissolution of the USSR, has performed very well. It is wisest for funds to hold nations' sovereign and quasi-sovereign debt rather than loans or corporate issues, which can be higher risk and offer a lower rate of return than foreign currency external bonds over the long term.
The most striking illustration of this was back in the 1980s, when Venezuela, Brazil and Mexico all devalued their currencies and reneged on their bank debts. But all three continued paying debt obligations on their eurobonds throughout to maintain access to private sector finance.
Holding bonds in emerging market currencies can also be problematic, as servicing repayments of debt in local currencies is more at risk of default than foreign currency eurobonds and Brady bonds. Local currencies can also be more vulnerable to inflation. For this reason, funds investing in this area should restrict their currency exposure to G7 currencies only, holding bonds denominated in dollars, euro or yen rather than any emerging market currency. This ensures that savings will not be vulnerable to fluctuations in the Brazilian real or the Venezuelan bolivar, for examp
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