Emerging market bonds: extra income but extra risk

In the last few months, we have talked about the opportunity in corporate and high yield bonds, but there is one area that has gone under the radar for many investors – emerging market bonds.

The entire emerging market bond universe is over $11trillion* and its bonds come in multiple forms. There is government debt as well as corporate debt and bonds in local currency or ‘hard’ currency (this is where companies or governments borrow money in a currency that isn’t their own - usually US dollars).

In the past five years the IA Global Emerging Market Bonds blended sector (funds that invest in a mix of hard and local currency bonds) has returned 34.60%**, vs 27.6%** for the IA Sterling Corporate Bond sector and 16.1%** for the IA Sterling High Yield sector. But, as you may expect, these extra returns have come with higher levels of volatility.

And, as with developed market economies today, there is the risk of a severe economic recession, brought on by the coronavirus pandemic, and therefore increased risk of company defaults. However, for the first time in modern history, emerging market central banks have been able to ease monetary policy in the crisis, with interest rates dropping to historical lows (albeit still in positive territory) to support economic activity during these difficult times.

Several central banks have also been able to purchase local bonds for the first time, with a significant degree of success, as well as loans from the world bank and a big increase in IMF emergency measures, providing a further cushion to the bond market. China has also reportedly agreed to suspend debt repayments for 77 countries as part of the G20 proposal for debt relief for poorer countries.

So, while risks remain, emerging markets could be a further opportunity for those looking to expand their sources of income-producing investments.

Investing in emerging market bonds

With such a variety of factors to consider, funds investing in the space need experienced managers. On the Chelsea Core Selection, our pick is M&G Emerging Markets Bond fund, run by Claudia Calich, who has returned 57.9%** over those past five years.

Claudia has the flexibility to invest across the whole emerging market bond spectrum. She begins by looking at the wider economic backdrop, analysing growth rates of countries and regions, their politics, central bank policies, commodity prices and inflation. Her views on these elements will dictate how much risk she wants to take at any given point and whether she prefers hard or local currency denominations.

While the fund is a little riskier than other bond funds, Claudia believes that careful and thorough credit research, with a focus on fundamentals, risks and valuations, is key to investing successfully in the emerging debt markets. The fund is currently also yielding over 5%^.

Other managers also like some of the opportunities afforded by emerging market bonds today. Ian Rees, co-manager off Premier Multi-Asset Monthly Income and Premier Multi-Asset Growth & Income, is one example.

“We use emerging market Bonds as a way to further diversify our income sources for our multi-asset income funds,” he told us. “The size and depth of these markets provides a wealth of opportunity in that regard. Supported by their superior growth characteristics throughout much of the emerging markets, this provides a more conservative way of benefitting from the wealth, governance and societal improvements in this region.

“On top of this, the relative valuation spread of emerging market bonds has grown more attractive in recent times, as investors have sought safety investing closer to home. We think the outlook for better starting yields makes the prospective risk-adjusted returns attractive. In accessing this potential, we have favoured an approach of investing with managers who have the capability and flexibility to move across hard or local currency and sovereign and corporate issues in finding the best opportunity.”

Craig Veysey, manager Man GLG Strategic Bond fund, is also finding opportunities in the asset classes with selective allocations to African, Asian and Latin American bonds^, while Richard Hodges, manager of Nomura Global Dynamic Bond fund, has both Russian and Egyptian bonds in his top ten holdings^.

In a recent FundCalibre podcast, he explained his enthusiasm: “If you're looking at 10-year Russia debt, you're getting a yield of around about 5.5%. When you're looking at the equivalent UK bond, you’re getting considerably lower, a tenth of that, if you're lucky. So, from an income perspective it looks attractive.

“From a capital perspective - remember, if you're investing in fixed income, fixed income gives positive returns when government bond yields or interest rates go lower - Russia, for instance, has consistently cut interest rates and short term interest rates, in our view, could be cut by another 1%, and they would still be yielding significantly greater than the UK. And that means we have a much greater capital opportunity of generating positive returns out of the likes of Russia, and even out of the likes of Egypt too.”

*Source: JP Morgan, 31 December 2018
** Source: FE Analytics, total returns in sterling to 13 July 2020
^Source: fund factsheet, 31 May 2020

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and managers quoted and do not constitute financial advice.