Look past emerging markets bond funds' sales pitch

By Dan Hallett, CFA, CFP

I was quoted in a recent Globe & Mail article warning that higher yields available in emerging markets bonds (compared to Canada bonds) come with additional risk.  Given that the investment fund industry has launched several emerging markets bond funds and exchange traded funds in recent years, it’s worth putting my comments and this growing class of funds into context.

Canada’s first generation EM bond funds

If memory serves, this latest string of emerging markets bond fund launches is round two for the Canadian investment industry.  When I started in the industry in 1994, emerging markets equities had just finished a year of triple-digit returns.  But unlike today’s focus on China and India, most of the enthusiasm back then zeroed in on Brazil and its Latin American counterparts.  Fidelity and Guardian were two sponsors of first generation emerging markets bond funds.

But a Mexican Peso crisis in late 1994 began a string of mid-late 1990s emerging markets currency crises.  They all put a dent in the market values of and infatuation with emerging markets bond (and equity) funds.

Fidelity Emerging Markets Bond Fund, for instance, was merged into its sibling, Fidelity American High Yield fund in 1999.  Similarly, Fidelity North American Income (sold by many advisors as a foreign money market fund) was merged into Fidelity Canadian Short-Term Bond after its big Peso sent the fund’s unit price southward.

Today’s EM bond funds – the pitch

Fast forward to today and there is a growing list of second-generation emerging markets bond mutual funds and ETFs.  And the sales pitch is striking a more sensitive chord today.  Developed countries the world over are up to their eyeballs in debt and sovereign default fears are abundant.  Emerging markets, on the other hand, sport skinnier debt-to-GDP ratios and are looked at as global economic saviours.  Accordingly, as developed nations are getting credit downgrades, emerging markets are being held out as safer credits.

But these supposedly safer credits are offering yields well in excess of bonds issued by more heavily-indebted developed nations.  Venezuela is an interesting example.  The country boasts a debt-to-GDP ratio of 39% and has seen GDP growth north of 4% year over year (according to www.TradingEconomics.com).

Yet 15-year Venezuelan bonds yield north of 12% annually according to Bloomberg.  Other Latin American government bonds yield 1 to 2 percentage points more than bonds issued by Canada, the U.S. and Germany.

Debt levels alone don’t predict emerging markets defaults

The sales pitch for emerging markets debt – like this one from RBC – might have us think that debt levels alone can be used to assess sovereign default risk.  But judging by the ‘spreads’ of emerging markets bond yields above developed world sovereign debt, the global bond market is saying that other important factors determine default risk.  Otherwise, emerging markets bonds would yield less than developed country debt.

In This Time is Different – Eight Centuries of Financial Folly, Carmen Reinhart and Kenneth Rogoff examined – among other things – a history of default among developing countries.  While high debt levels were universally linked to default episodes, the authors found that emerging markets defaults have generally occurred at debt levels that are generally considered ‘safe’ for more mature economies.

They found that nearly half of the three-dozen emerging country defaults between 1970 and 2008 occurred at debt-to-GNP ratios below 35 percent.  One recent illustration of this is Ecuador’s 2008 default which occurred at a debt-to-GNP ratio of 20 percent.

While developed countries tend to run a higher risk of default at debt-to-GNP ratios above 60%, history suggests that the danger zone for emerging markets typically starts at 35%.  While emerging markets countries boast lower overall debt levels, they also are less willing and less able to shoulder as much debt as their more developed peers.

Reinhart and Rogoff suggest that pinpointing any one country’s debt intolerance threshold (or where the risk of default rises significantly) may largely be a function of a country’s own history of default and inflation.  In other words, the global bond market and the credit default swap market generally consider emerging markets higher default risks for good reasons.

Including emerging markets debt in portfolios

Our firm has never explicitly included emerging markets debt as part of client portfolios.  Those who can’t resist the lure of this class of global bond should keep a few things in mind.

When determining allocation limits, include emerging markets bonds into the larger bucket of higher yield bonds.  Common guidelines limit high yield (and in this case emerging markets) bonds to between 33% and 50% of total bond exposure.  But for some investors the appropriate exposure might be zero.  Whatever the case, all investment policy guidelines should be driven by individual goals – which can’t be stressed enough.

Too many investors and their advisors will gravitate to emerging markets bonds because of the lure of the sales pitch and the returns in recent years.  Our approach is to build portfolios with ‘core’ and ‘enhancement’ building blocks.  We begin with ‘core’ exposure; and only when that is insufficient to achieve stated goals do we introduce ‘enhancement’ strategies – like higher yield bonds – to juice portfolio return potential.

Those simply chasing returns, however, tend to have unrealistic expectations – which is bound to end in disappointment.

 

   
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11 comments to Look past emerging markets bond funds’ sales pitch

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  • Ron Stagg

    Hello Dan,

    Thank you for that very informative article, especially the Reinhart and Rogoff research.

    I look at the yield to maturity of these funds (where it’s available), as an indicator of the return to expect over the next few years.

    For example, the RBC Global High Yield Bond Fund has a YTM of approximately 6%, from which you subtract the MER.

    What is your opinion of this fund?

    Regards,

    Ron Stagg

  • An advisor and loyal reader

    I’m not sure if the Ecuador example really counts as a debt default. Most believe it to be a purposeful “political” default although it does highlight a different kind of risk than typical debt:GDP ratios. Politically, it you use the leading and sizeable (US not Cdn ver) Templeton Global Bond fund as an example, the risks of debt instruments from South Korea, Australia, Singapore, etc seems to be more palpable and more evident. Then again, I never thought people would actually be stupid enough to buy GICs @ 1.5% while RY has a dividend yield north of 4.0%.

    http://www.portfolio.com/views/blogs/market-movers/2008/12/12/ecuadors-idiotic-default/

    http://blogs.reuters.com/felix-salmon/2009/05/29/lessons-from-ecuadors-bond-default/

    http://www.ips-dc.org/articles/ecuadors_debt_default_exposing_a_gap_in_the_global_financial_architecture

  • Thank you Ron. Reinhart and Rogoff is packed with information but be warned that it’s like a 200 page academic paper (i.e. not a quick read). The RBC Global High Yield Bond is a good example of a broader mandate fund that includes emerging markets.

    And it’s incorporated into this one fund in the same way that I’d suggested above. And with fees of 1.76% per year, it’s reasonably priced compared to other similar funds. I don’t know this fund really well but it looks pretty good at first glance. And RBC has a solid money management team.

  • Advisor – thanks for your comments and links. You make an excellent point that I hinted at in the article but didn’t explicitly point out. That is that the notion of “debt intolerance” that Reinhart and Rogoff explore speaks to a country’s willingness to make payments on their existing debt and shoulder additional debt.

    So politics plays a larger role in emerging markets default risk than it does in developed country default risk. Your other good point is that not all emerging markets countries have equal political risks and it’s quite debatable whether South Korea should be considered an emerging market. But the point that it’s worth looking at what your fund is holding.

    Keep in mind that like the RBC fund above, Templeton Global Bond has a broader mandate that includes government bonds (developed + emerging markets) and corporate bonds (investment grade + high yield) which again is, in my view, a better way to get some EM bond exposure.

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  • An Advisor and loyal reader

    Dan,
    IMHO, that RBC Global High Yield Bond fund looks strong by the M* 4* rating but the the credit quality of the bond issues is night and day different than the Templeton Global Bond fund. The RBC is over 60% below investment grade bonds with only 5% of the bonds rated A or higher. The Templeton Global bond is 88%. The Templeton bond has a duration of 2.0yrs and monthly income distribution and the RBC has a duration of 5.4yrs and a quarterly income distribution. Given the marginal difference in the YTM, you’re simply taking significantly more risk to generate a modest excess return with the RBC bond.

    But you know what I really don’t like about the RBC fund? It appears to perform like an equity in periods of down markets.

  • Thanks for raising a point that I should have made when mentioning both of those funds. Yes, the RBC Global High Yield Bond is mandated to focus on lower quality credits (i.e. higher credit risk). Templeton Global Bond, however, is much broader, will tend to focus on investment grade but may have a bit of below-investment-grade debt. But thank you for quoting some figures to put this into context.

    As to your final comment, it’s true that so-called ‘junk’ bonds will behave more like equities than high quality bonds. That’s why I’d suggest lumping emerging markets debt and below-investment-grade corporate debt into a broader ‘bucket’ of higher-yielding bonds – and apply portfolio maximums to that broader bucket.

  • Doug Cronk, a member of CPPIB‘s investment team, posted a good article on this same topic just recently – Emerging Markets Bonds. Some of his data is worth examining. Actually, the whole thing is worth reading since he provides a better overview than I did above.

    As I read his post, it started to sound like an endorsement for EM bonds. But I found it interesting that he concluded that he wasn’t yet convinced – at least for pension plans – that EM bonds deserve a separate long-term allocation. In any case, his different focus (vs my post above) makes it a nice compliment to this post and well worth reading.

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