Many investors focus their fixed-income investments on domestic or developed market bonds, without considering emerging market (EM) bonds. Yet, EM bonds have produced consistently strong total returns over the last several years. Today the EM debt market is considerably larger and less risky than it was 10 years ago and is expected to continue to develop over time. The ability to provide significant diversification and deliver superior long-term total return potential has made this an increasingly important asset class for a wide range of investors.
Four reasons why now is the time to consider emerging market bonds for your portfolio:
1. Increasingly higher quality offerings. Investors often compare emerging market bonds with high-yield bonds, but the comparison can be misleading. High-yield bonds are below investment grade by definition. But to the surprise of many investors, 56.4% of emerging markets bonds are now rated investment grade, compared with only 16.5% in 1998 (JP Morgan, as of June 2010).
This credit rating increase is partly due to the overall improved fiscal health of emerging market economies. The debt-to-GDP ratio is one gauge of a country’s fiscal health and the sustainability of its borrowing levels. Many emerging market countries’ debt-to-GDP ratios are relatively low compared with their Western counterparts, many of which are struggling with high debt levels in the wake of the financial crisis of 2008. For example, China has only $17 dollars of debt for every $100 of GDP, whereas Japan has $189 of debt.
2. Growing market size and liquidity. Emerging market economies account for 43% of global GDP as of 2007, but emerging market bonds only account for 11% of the global fixed income market, as the illustrations show. This indicates that there’s room for additional growth as local markets deepen and diversify, which would improve overall liquidity.
3. Strong yields. If you are searching for more yield than the historically low levels now offered by developed country government bonds but don’t have the risk appetite for high-yield bonds, emerging market bonds can be an excellent alternative.
Emerging market government bond yields are typically higher than those offered by other sovereign bonds. This is to compensate bondholders for taking on the added risk of investing in countries with shorter records of sound economic policies and less-established institutional government frameworks.
But due to concerted efforts since the mid-1990s to implement strong fiscal policies and structural reforms, which proved effective in the recent global crisis, many emerging market bonds are now rated investment grade. The risk premium is expected to continue to narrow, which should reward current investors.
4. Impressive performance. While developed markets deal with the fallout from the 2008 and 2009 financial crisis, emerging markets are considered by some economists to be the “growth engine” of the global economy.
Emerging market governments have learned valuable lessons from the sovereign debt crises and currency devaluations of the mid- to late-1980s and have since transformed their fiscal situations. Most introduced flexible currency exchange rates, accumulated vast reserves of foreign currencies and reduced their debt levels. Combined with strong demand for exports, rising consumer spending from an increasingly wealthier population and a growing number of young, well-educated workers, these policies have set the stage for continued economic growth.
Inflation in the region has remained well contained, with core inflation (i.e., excluding food and energy) below 3.5% in most countries.
Against this backdrop, emerging market bonds have delivered solid returns to investors over the past several years and stacked up favourably against Canadian bonds.
Emerging market bonds can provide strong diversification
Allocating a portion of your assets to emerging market debt can provide significant growth potential and compelling diversification benefits, as emerging market bonds behave very differently than assets in developed markets. It can also be an excellent way for investors to access the opportunities emerging markets can provide with less risk than investing in emerging market equities.
Jean Charbonneau is Senior Vice-President and Portfolio Manager at AGF Investments Inc. and is responsible for the overall management of AGF’s fixed-income team. He is Portfolio Manager of AGF Emerging Markets Bond Fund, AGF Emerging Markets Balanced Fund, AGF Global Government Bond Fund, AGF Global Aggregate Bond Fund, and AGF Pure Canadian Balanced Fund and co-manager of AGF Canadian Bond Fund and the fixed-income component of AGF World Balanced Fund. For more information on AGF’s fixed-income product offerings, visit AGF.com.
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