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Emerging Market Bonds: Stay Underweight or Jump In?

Key Points
  • We suggested underweighting emerging market bonds in November 2017 due to high valuations and rising risks associated with tighter monetary policy. Valuations have improved due to a selloff in EM bonds and currencies, but we still suggest staying underweight.

  • Valuations: Yields for EM bonds have risen in the past few months, widening the yield spread versus Treasuries, but investors still aren’t getting much compensation for the risk of further price and currency declines.

  • Risks: With the Federal Reserve and other major central banks moving ahead with plans to tighten monetary policy, the dollar is rebounding and real interest rates are rising, which could make it harder for EM companies and to finance their debt.

Our major theme over the past year is that investors should prepare for the “end of the era of easy money.” We anticipated that with the Federal Reserve and other central banks tightening monetary policy, the days when investors were willing to take large risks in exchange for small rewards would end. As yields on Treasuries rose, investors would begin to demand increasingly higher yields on riskier bonds, resulting in lower prices in those segments of the market. It appears that the process has begun.

Last fall, we singled out emerging market bonds in particular for risks and suggested underweighting the asset class. Recently, EM bonds have underperformed developed market bonds, as yields are moving higher and currencies are falling. While there are some one-off factors affecting the various countries, the overall result has been a selloff in most EM bonds and currencies.

Emerging market currency performance

Emerging market currencies did not perform well between April 13 and May 14, 2018. At the bottom of the scale was the Argentine peso, which lost 19.08%, and Mexican peso, which lost 8.04%. At the top was the Russian ruble, which gained 0.28%.

Source: Bloomberg. Emerging Market World Currency Spot Return. Date range 4/13/2018-5/14/2018. Past performance is no guarantee of future results.

 

Even after the recent selloff, EM bond yields haven’t reached levels that we see as attractive on a risk/reward basis. Valuations still appear high. The yield spread of U.S. dollar-denominated EM bonds compared to Treasuries has moved up sharply to 2.7% in the past month, but remains below the post-financial crisis average of 3.3%.1

Emerging market bond spreads spike, but remain below post-financial crisis average

The yield spread of U.S. dollar-denominated EM bonds compared to Treasuries has risen to 2.7% in the past month, but remains below the post-financial crisis average of 3.3%.

Source: Bloomberg Barclays Emerging Markets USD Aggregate Bond Index, monthly data as of 5/14/2018.

Note: The post-financial crisis average of 3.3% was calculated by using the date range of 6/1/2009 to 5/14/2018.

 

For countries and companies that have borrowed in U.S. dollars, further declines are possible. As the Fed hikes rates it’s likely that the U.S. dollar will continue to firm up, making the repayment of debt by foreign entities more expensive. Over the past decade, issuance of U.S. dollar-denominated debt by EM countries and companies has soared to over $1.2 trillion from just $220 billion,² leaving a large portion of the market vulnerable to a rise in the dollar. Argentina is running into this problem. Having issued a 100-year bond in U.S. dollars last year, the country is now having difficulty paying bondholders and has asked for help from the International Monetary Fund.

Debt issued in local currencies won’t face that problem, but there are other risks to consider. Demand is likely to ebb as U.S. rates rise. Also, investors, facing the prospect of being repaid in cheaper currency, are likely to demand higher yields, generally sending bond prices lower. Historically, EM local currency bonds have been more volatile while delivering lower returns than U.S. dollar-denominated bonds. The chart below illustrates that local currency EM bond returns have been almost twice as volatile as U.S. dollar-denominated EM bonds over the past five years, with significantly lower total annualized returns.

From May 2013 to April 2018, annualized return for the Bloomberg Barclays EM Local Currency Index was minus 0.13%, while standard deviation was 9.52%. Return for the Bloomberg Barclays EM USD Aggregate Bond Index was 3.24% and standard deviation was 5.23%.

Source: Bloomberg Barclays Emerging Market Local Currency Index and Bloomberg Barclays Emerging Market USD Aggregate Bond Index, 5-year annualized standard deviation and total return. Data range used May 2013 to April 2018. Past performance is no guarantee of future results.

 

Today the yields on local currency EM bonds are below those of U.S.-dollar denominated EM bonds, so investors aren’t being compensated well for the potential for greater volatility and the heightened currency risk. Historically, local currency bonds have yielded about 14 basis points less than U.S. dollar-denominated bonds, but today the yields are almost 50 basis points lower. Investors in local currency EM bonds today are therefore facing lower relative yields compared to the past decade, but also the risk of falling currencies when the dollar is rising.3

The yield difference between USD-denominated and local currency EM bonds is about 50 basis points

As of May 11, 2018, the yield-to-worst for the Bloomberg Barclays EM USD Aggregate was 5.48%, while yield to worst for the Bloomberg Barclays EM Local Currency Government Index was 4.9963%, a difference of nearly 50 basis points.

Source: Bloomberg Barclays Emerging Market USD Aggregate Bond Index and Bloomberg Barclays Emerging Market Local Currency Government Bond Index, Yield to Worst. Monthly data as of 5/11/2018. Yield to worst is defined as the lowest potential yield that can be received on a bond without the issuer actually defaulting.

 

A number of other risks appear to be rising. Slowing growth in China raises risks for Asian emerging market countries that rely on exports to China. Also trade disputes and political uncertainty have been on the upswing from Mexico to Malaysia recently.

Overall, we still suggest maintaining an underweight allocation to EM bonds despite the recent rise in yields. Valuations are still not attractive on a risk/reward basis. With the Federal Reserve and other major central banks moving towards tighter monetary policy and rising political risks, we see the potential for EM bonds to continue underperforming core U.S. bonds.

 

1 Post-crisis average is from 6/1/2009 through 5/14/2018.

2 Source: BofA Merrill Lynch U.S. Emerging Markets Liquid Corporate Plus Index (EMCL). Monthly data as of 11/30/2017.

3 Average yield difference from 6/30/2008 through 5/11/2018.

 

What You Can Do Next

  • Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
  • Explore Schwab’s views on additional fixed income topics in Bond Insights.
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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Currencies are speculative, very volatile and are not suitable for all investors.

The Bloomberg Barclays Emerging Markets USD Aggregate Bond Index is an emerging markets debt benchmark that includes USD-denominated debt from sovereign, quasi-sovereign, and corporate EM issuers.

The Bloomberg Barclays Emerging Market Local Currency Government Bond Index measures the performance of local currency emerging markets debt. Classification as an EM is rules-based and reviewed annually using World Bank income group, International Monetary Fund country classification and additional considerations such as market size and investability.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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