Should You Own Emerging Markets Bonds?

Diversification represents a sound principle of portfolio construction. Spreading risk around whether pertaining to stocks, bonds, real estate, or other assets, is one of the prime ways in which investors can get a good night’s sleep.

In the bond world, investors can spread risk by investing in individual bonds, bond funds, corporates, municipals, Treasuries, junk, and yes, international and emerging markets bonds. I would opine, however, that just because there is the opportunity to invest in something does not mean you should necessarily invest in it.

Investors in lower tax brackets, for example, probably would not benefit from diversification to municipals, due to their lower absolute yields compared to corporates with similar credit quality and duration. And some may ignore Treasuries because they possess lower yields than corporates.

To see a list of high yielding CDs go here.

But what about emerging markets bonds? Is there sound rationale for diversifying a primarily domestic fixed-income portfolio there?

As a general rule, emerging markets bonds are considered riskier than domestic issues due to the unique set of variables they present. Political, currency, and general economic risk would probably be the biggest differentiators as compared to domestic or more developed nation bonds. Due to their high yields, emerging market bonds – both sovereign and corporate – might be considered somewhat on par with junk corporate debt. Although just like domestic high-yield, some emerging markets bonds would be considered more creditworthy than others. So if you are disinclined to invest in domestic high yield, or have some other aversion to investing overseas, this is a space to likely avoid.

If you possess the risk tolerance to consider emerging markets bonds, probably the best way to expose oneself is through pooled products, namely ETFs and CEFs. While you could certainly diversify amongst individual names, I would hasten to say that most individual investors probably don’t have the time to do the due diligence that would be required to create a sensible portfolio.

I did a search recently on CEFconnect.com and came up with the following list of options for those considering emerging market bonds:

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As we can see, these funds all trade at discounts to net asset value (NAV), and possess yields in the 6-8% range, with a couple of outliers.

On the ETF front, iShares offers a small basket of emerging markets funds:

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The iShares funds all yield below 6%, are non-levered, and possess lower management fees – in the 60 basis points range – so less than half of what most of the closed-end fund management companies charge.

If we compare both CEF and ETF yields to payouts available in the junk bond space, it would seem that CEF yields are somewhat comparable, while the iShares products lag. Of course yield alone is not reason to buy or avoid a certain fund since they all may possess varying blended credit profiles and durations. Just like any bond, the lower the credit profile and longer the duration, the higher the yield will be.

From a capital perspective, just like junk credit, there can be upside to investing in emerging markets bonds if the issuer’s ratings improve. Thus, depending on what one’s belief is regarding forward prospects of specific emerging economies, their debt can represent an appreciation idea in addition to the coupon received on the bond – i.e. a total return opportunity.

In the end, I’m not sure that emerging markets debt, on a whole, presents a tantalizing opportunity for investors, when domestic high-yield debt presents similar coupon with less political and currency baggage. Discounts in the CEF space always seem to be rather compelling however and offer additional risk mitigation for those perceiving elevated pitfalls in the space. I’ve always been fond of Western Asset Emerging Markets Debt (ESD), although I do not currently own the fund.

So while there is certainly some diversification benefit and perhaps total return potential  to adding emerging markets debt exposure to a taxable income portfolio, I don’t think I’d recommend going in head over heels, unless one has a more bullish thesis than I have at the moment.

About the author:

aloisiAdam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.

 

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