Finding attractive sources of income has become more challenging in the post-crisis era as interest rates hover near record lows (see the chart below). A large and growing share of government bonds are negative yielding, especially in Europe and Japan. While yields are still positive in the U.S. and Canada, they offer little protection against inflation. In addition to these challenges, the Canadian government bond yield curve is currently inverted (long-term bond yields are below short-term yields), meaning domestic investors receive less income for taking greater levels of interest rate risk.
Lower potential growth due to shifting demographics, the rise in global savings, stable inflation, low inflation expectations, and a shortage of positive yielding, safe-haven assets will likely place downward pressure on yields. To achieve investment objectives, income seekers may need to climb the risk-return spectrum. For those with greater risk tolerance, emerging market (EM) bonds could present a compelling opportunity to enhance the yield of a portfolio. Below we offer three important considerations when investing in emerging market bonds. We focus on hard currency, or U.S. dollar-denominated, EM debt as it’s the most liquid exposure available to Canadian ETF investors.
1) Fundamentals are improving
EM debt and high-yield bonds offer substantially higher yields and are riskier than government bonds. However, and perhaps contrary to popular belief, EM fixed income has a notable difference from high yield: most of the securities are rated investment grade. Moreover, the share of EM bonds rated investment grade has risen over the long run, coinciding with the proliferation of economic and policy reforms.
Greater access to global capital markets and some notable country-specific shocks have raised concerns in recent years around the sustainability of EM finances. While problems exist, EM governments are generally in decent fiscal shape and are relatively less leveraged than their developed market peers (see the chart below). The median government debt-to-GDP ratio for richer countries is nearly double that of the developing world. While government debt ratios have increased since the global financial crisis, they’ve risen at a slower pace for EM economies, thanks in part to faster economic growth. Low-income developing countries have also worked to correct previous debt imbalances. Overall, sovereign EM bond fundamentals appear relatively stable today.
2) EM debt is well diversified
The sovereign EM bond universe is well-diversified geographically, especially compared to EM stocks (see the chart below). No single country makes up much more than 5% of the EM bond benchmark, with most countries representing less than 2% of the index. This helps investors minimize exposure to country-specific or idiosyncratic shocks in pockets of the EM world. In contrast, EM equities are more concentrated, with the largest holding in the benchmark being China, comprising nearly one-third of the investable market.
In terms of regional distribution, EM debt has substantially less exposure to Asian economies, which effectively dominate the EM equity index. Instead, hard-currency EM debt is more tilted towards Latin America with relatively greater representation from the Middle East and Africa. At a time when tensions between the U.S. and China have reached new heights, accessing emerging markets through debt instead of equity could be a way to mitigate exposure to the ebb and flow of trade frictions.
3) Hedging decision doesn’t need to be complicated
Canadians investing abroad are faced with an additional layer of decision making: whether to hedge foreign currency exposure or not. Generally, we believe fixed income investors should hedge currency risk in the long run since currency tends to add substantial volatility to a bond portfolio (see the chart below). However, when it comes to riskier segments of the fixed income market, such as EM bonds, the hedging decision is less consequential as currency tends to account for a much smaller share of total risk. Hedged or unhedged, the historical volatility of EM debt has been roughly the same.
From a performance perspective, hard currency EM debt returns tend to be stronger when the U.S. dollar is weakening relative to other currencies, including the Canadian dollar (see the chart below). There are a few possible reasons why: Firstly, a weaker U.S. dollar makes dollar-denominated debt loads easier to pay off. Secondly, a weaker U.S. dollar may be associated with declining U.S. interest rates or an easing U.S. Federal Reserve, which can lead to portfolio inflows for EM assets. Lastly, the Canadian dollar tends to show pro-cyclical behavior, strengthening during periods of improving global growth and risk-appetite – this relationship has held true so far in 2019. Having a favourable view on hard currency EM bonds would be consistent with wanting to hedge the U.S. dollar.
Daniel Donato is an Associate within BlackRock’s Toronto office.