By William Sokol, Product Manager at VanEck.
According to VanEck, emerging markets bonds offer higher risk premiums, increased income producing potential, and enhanced portfolio diversification.
Increasing strategic allocation to emerging markets bonds promises more benefits that just higher risk premiums. As the asset class continues to grow both in size and diversity, emerging markets bonds can boost income producing potential and provide unique diversification.
Low correlation offers unique diversification
An analysis of the past ten years shows that emerging markets bonds generally exhibit moderate correlation to other core fixed income asset classes, particularly when compared to US equities.
While the correlation between US high yield bonds and US equities is 0.73, local currency emerging market bonds correlate only 0.62. Even US dollar-denominated emerging market bonds exhibit only a correlation of 0.58 to US equities. The correlation is slightly higher for emerging markets high yield bonds at 0.67.
Correlation of Monthly Returns: January 2007 – December 2016.
Source: VanEck.
The generally lower correlation of emerging markets bonds to US equities can indicate a higher potential for diversification within an investor’s credit portfolio.
Emerging markets bonds boost income producing potential
Besides the lower correlation and high yields, emerging markets bonds may boost the income producing potential of a portfolio. This is shown by the analysis of the weighted average yield to worst (YTW), the lowest potential yield that can be received on a bond without the issuer actually defaulting.
Emerging markets corporate high yield bonds achieved the highest YTW of all fixed-income classes with 6.95%. To compare: The YTW of US high yield bonds was 6.12%. With an YTW of 6.65%, emerging markets local sovereign bonds came in second.
Yield Comparison: As of 31 December 2016.
Source: VanEck.
Overall, allocations to the various sectors of emerging markets bonds have historically provided investors the opportunity to enhance yield and diversification within a diversified portfolio. However, investors should keep in mind that there is significant diversity within emerging markets bonds. Each country has a unique economy with differing policies and social and political structures which can impact long-term investor returns. Each is affected differently by shifts in interest rates (US and local), currencies, and credit spreads. As a result, each sector may exhibit very different risk and return profiles over a given time period. Investors may not realize the full benefits of emerging markets bonds with exposure to only one of these sectors.
A strong investment rationale for emerging markets bonds
At VanEck, we believe the long-term investment rationale for emerging markets bonds remains strong as the asset class continues to grow in both size and diversity. Over the past several decades, emerging markets economies have evolved and are today characterized by more dynamic and less vulnerable economies. Economic growth, although slowed by recent headwinds, has remained higher than in developed markets and is expected to increase.
We believe emerging markets debt will remain attractive for income-seeking investors, who may benefit from the yields the asset class can potentially provide, as well as supportive fundamentals and global monetary policies. Investors must balance the potential yield achieved with the additional risks associated with these investments, such as foreign exchange rate or political risk. However, with generally low allocations to emerging markets bonds in many global bond funds, we believe this asset class warrants a strategic allocation given the unique characteristics and opportunities it can offer.