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Emerging Market Bonds: Are Yields High Enough?

Tuesday, July 15, 20140 comments

Emerging Market Bonds: Are Yields High Enough?

It is the wise investor who looks not only at markets offering opportunity but also at markets at risk. There is no sure-fire way of identifying markets that may be at pricing risk. I have usually observed variables that tend to indicate, based on historical relationships, markets that may be offering opportunities for outsized returns, as well as markets that may be at risk. During times when overall valuation levels (for the main-line stock and bond markets) have become stretched by historical terms, it normally pays to seek markets that appear overvalued and avoid those overvaluations. Currently, one such market appears to be the Emerging Country Bond Market. I believe that risks abound in this market. Returns of the Emerging Debt Market – In U.S. Dollars In a world of low interest rates, many investors have been scrambling for yield. In some cases, ill-founded risks are being taken in portfolios in an attempt to generate yield. As investors have scrambled to purchase riskier assets, valuations have risen. One such area where valuations appear stretched, both on absolute and relative value levels, is the emerging bond market. It is interesting to note how strong total returns have been in the emerging debt market (represented by the J.P. Morgan EMBIG Diversified Index) as compared to the Barclay Aggregate Index (a broad-based bond index): 2Q2014 YTD 2014 12/31/11-6/30/14 Emerging Market Debt +4.8% +8.7% +20.9% Barclay Aggregate Index +2.0% +3.9% +6.1% Now, don’t get me wrong. Just because one segment of the bond market is outperforming another broader index does not make my alarm bells chime. However, this level of outperformance of one major area of bonds as compared to another is worth further investigation. Is this level of outperformance sustainable? I doubt it. Absolute Yields – Are the Emerging Debt Markets Still Attractive? With many of the world’s investors convinced that inflation and economic growth will remain subdued, interest rates have been driven to historically low levels. The emerging market bond index now yields 5.1%. Is this a reasonable yield? Are investors being paid for the risks they are assuming? Following are some facts regarding the emerging debt markets credit risks: The EMBIG index contains an average credit rating of BBB- (barely investment grade). Since 2001, the credit rating of the bonds in this index has risen from BB- (below investment grade). Consequently, the credit quality of the emerging bond market space has improved overall, but is still lower than some investors would prefer. South American debt dominates the sovereign (government) portion of the emerging bond market, at 36% of the index as compared to 19% exposure to Asia. This is somewhat disheartening given the historical tendency of Latin governments toward default and financial shenanigans (note the current dislocation with Argentina). Some might suggest that a yield of 5.1% is high enough to absorb the risks inherit with these credit facts. Maybe. But, we saw last week what can happen to the emerging bond space as a small but meaningful bank in Portugal (Banco Espirito Santo) defaulted on one of its obligations. These events can and do happen in the emerging market bond space. Another factor to consider is maturity. The bond index cited above carries an average maturity of 12.1 years. This is a rather long maturity bond index. At a yield of 5.1%, is an investor being compensated for credit risk, political risk and duration risk? Some would say no. Relative Risk Factors – Where We Have Come From? Before we pass judgment on the emerging bond market space, let’s take a peek at current relative to historical yield spreads. Are current yields competitive compared to other alternatives? At a yield of 5.1%, the emerging bond market index is yielding 2.6% above 10-year U.S. Treasuries. Over the last 15 year period, emerging bond yields averaged a positive spread of 4.38% to 10-year U.S. Treasuries. If the emerging bond space was priced as it normally has been relative to 10-year U.S. Treasury yields, emerging bonds would yield 6.9%, not 5.1%. There has only been one time when the emerging bond market spread to U.S. Treasury yields was lower than today – that was in 2007, prior to the bond market debacle of 2008-2009. As a side-note, during the 2008-2009 bond market route, the spread of emerging debt yields to U.S. Treasury yields rose to 10.2%. During 2008, as the yield spread moved upward, the emerging bond index lost 12.0% in value, while the Barclay Aggregate Index returned 5.2%. Some are making the case that based on spread analysis; emerging debt yields are attractive relative to corporate high-yield bonds. Perhaps. But, perhaps yields in the corporate high-yield space are, like emerging market bonds, simply too low due to investors’ search for yield. Bottom Line – Look Elsewhere At an absolute yield of 5.1% and a relative yield of 2.6%, we suggest investors are not being properly compensated for all the risks emerging bonds entail. Along with interest rate risk, there are historical valuation risks inherit in the emerging space. Lastly, political risks abound in this investment arena – simply look at the headlines radiating from Argentina, Portugal and Greece. Conservative investors may want to look elsewhere for yield.
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The views expressed are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. It is not intended to be personal legal or investment advice or a solicitation to buy or sell any security or engage in a particular investment strategy.
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