Emerging market bonds attract with high interest rates. But they are far too risky to replace safe European government bonds. Instead, emerging market bonds look good in the portfolio when investors add them to the equity component. Shares in companies from emerging markets are now an integral part of internationally diversified investment portfolios. The MSCI Emerging Markets Index, which the stock market development of 24 emerging countries such as Brazil, China and Russia, is observed by many investors as a barometer of sentiment. In contrast, very few investors have heard of the JP Morgan Emerging Markets Bond Index (EMBI). It mainly contains government bonds from emerging markets as well as a small proportion of bonds from state-controlled companies – a segment that many investors have not yet looked into. Because the global emerging market bond market is small. It has grown strongly over the past two decades.
Investors prefer emerging market bonds in US dollars
More than 60 percent of the emerging market bonds outstanding at the end of 2017 were issued in so-called hard currencies, primarily in US dollars, but also in euros and yen, because many international investors do not trust local emerging market currencies. For example, US investors stay away from fluctuations in exchange rates spared when they invest in US dollar bonds from emerging markets. The respective issuer has to stand upright for the local currency to decline in value. This is different for emerging market bonds issued in local currencies. In this segment, foreign investors generally have to bear a currency risk. For investors from the euro area, this also applies to bonds in US dollars.
How much return do emerging market bonds bring?
Government bonds from emerging countries typically offer higher yields than bonds from mature industrial countries such as the US and Germany, which are considered safe. The average yield premium for emerging market bonds in US dollars was around 3.6 percentage points per year from 2008 to the end of 2018. Compared to German government bonds , the yield of which was far below that of US government bonds, the premium was even higher at the end of October 2018: the effective interest rate of an exchange-traded index fund, or ETF for short, which contains 416 emerging market bonds in US dollars from more than 32 countries 6 percent annually with an average remaining term of 11.85 years. German government bonds due in early 2030, on the other hand, only offered a yield of 0.38 percent per year.
What drives emerging market bond yields
The total return on emerging market bonds consists of the coupon, exchange rate gains or losses, and exchange rate gains or losses. While short-term exchange rate fluctuations dominate the performance, in the long term the interest coupons are decisive. The latter are usually firmly agreed. The coupons are paid regularly by the issuers as long as no country gets into financial difficulties. The interest payments are largely predictable income.
The price development of the bonds and exchange rate fluctuations, however, are anything but predictable. Both are influenced by a variety of factors. The rating plays a very important role in the bond prices. If a country’s credit rating is downgraded, bond prices usually fall – and vice versa. The US Federal Reserve, which influences the interest rate level in the US dollar area, is also a decisive factor. When US interest rates rise, most emerging market bond prices fall- in both US dollars and local currencies. International investors withdraw capital and place it in US bonds. They also dissolve so-called carry trades, which are riskier and less lucrative because of the lower interest rate differential. This leads to further capital outflows from emerging market bonds- prices fall.
Investors also react to changes in the political environment. If stability falls, as in previous years in Brazil, where the involvement of leading politicians in corruption scandals rocked the largest economy in Latin America, bond prices often fall too. Investors assume that the risk of default increases when a state is no longer run by a solid government.
Important macroeconomic indicators that investors watch with hawk eyes are also the debt ratios of emerging markets and their current account. Rising debt ratios and increasing imports than exports, which add to the current account deficit, are not doing well with lenders. Conversely, falling debt and current account surpluses support bond prices.
Diversify your portfolio with emerging market bonds
However, investors should not focus too much on the performance of the individual investments in their portfolios. What matters is the interaction of the various depot modules and the overall result that they deliver. Emerging market bonds have also played an advantageous role in this area in the past. Used correctly, they lower risk and increase returns in mixed investment portfolios. First, the analysts examined portfolios that consisted only of developed market bonds and gradually added an increasing proportion of emerging market bonds denominated in US dollars.
Result: The portfolio return increased, but at the same time the volatility increased even more.
The result: In relation to the risk, the higher the proportion of emerging market bonds in the portfolio, the further the return fell.
This shows that emerging market bonds are no alternative to secure bonds from European countries. No matter how tempting the high interest rate may be, investors increase their risk disproportionately if they swap emerging market bonds for industrial country bonds in their portfolios.