Sunday, December 6, 2009
Emerging Market Bonds Don't Make Sense to Me...Unlike Emerging Market Stocks
click on any chart to enlarge
The recent new stories about Dubai's debt (as well as that of Greece and a list of others) got me to revisit my thoughts on emerging markets bonds. I haven't changed my mind...they don't make sense to me as part of a portfolio.
The rationales for holding emerging market bonds are that it is a diversifier for portfolios, that it offers a way to participate in the growth of emerging markets and that it offers a yield pickup compared to US treasuries. I'm not convinced.
The lowest cost and most readily available vehicles for investing in emerging market debt are the ishares etf (ticker emb) and the powershares etf (PCY). Both invest only in dollar denominated debt.
In my view investors looking to participate in the growth of the emerging markets are far better off doing so through equities. And those looking for a yield pickup would be better advised to look at high yield corporate debt.
First off, these vehicles since they invest only in dollar denominated debt, do not offer currency diversification a major reason to add international investments to a portfolio. Secondly although the correlation statistics vs US bonds is relatively low for the entire (short) period that they have been in existence it is important to remember the limitations of simply using such statistics. As is well known, the only thing that goes up in a down market is correlation. And it is in the down markets particularly the extreme down moves that one most wants diversifiers in a portfolio. As can be seen in the charts above comparing emerging market stocks (blue), the sp 500 (brown) and PCY (black), the powershares emerging markets debt etf offered little shelter during the most severe drops of last fall. Yes 2008 ended with PCY outperforming the emerging market stocks vs -48.9% vs -18.8% but it was not necessarily a diversifier, it simply had less volatility. The comparison charts are for two years(top chart) and ytd (second chart).
This year's performance shows that emerging market debt is far inferior to equities as a means to participate in the growth of emerging market economies. The eem is up 68.8% this year vs (a still very impressive) 36.18% for PCY. But I would argue that the eem is far better to gain exposure to emerging market growth. And the logic is simple: the fastest growing emerging market economies have little if any debt. And the emerging market debt etfs have holdings based on a weighting of soivereign debt outstanding
This brings me to the most important distinction between emerging market bonds and emerging markets stocks. The stongest performing emerging markets run current account and budget deficits and therefore (with the major exception of Brazil) have little sovereign debt. For that reason the country allocation of the emerging market bond etf offers far less exposure to the fastest growing emerging market economies. Compare this list of top country holdings in the emerging markets stocks etf (eem)
South Korea 12.43%
South Africa 8.08%
Hong Kong 6.84%
Now compare the top holdings of the ishares emerging markets bond etf
Russian Federation 10.22%
South Africa 4.68%
Venezuela, RB 4.49%
and the top holdings of the powershares bond etf
UKRAINE GOVT 7.0%
REPUBLIC OF INDONESIA 5.5%
REPUBLIC OF TURKEY 4.7%
REPUBLIC OF EL SALVADOR 4.7%
REPUBLIC OF COLOMBIA 4.3%
REPUBLIC OF SOUTH AFRICA 4.2%
STATE OF QATAR 4.2%
REPUBLIC OF PANAMA 4.2%
RUSSIA FEDERATION 4.2%
REPUBLIC OF PERU 4.1%
SOCIALIST REP OF VIETNAM 4.1%
UNITED MEXICAN STATE 4.1%
REPUBLIC OF PHILIPPINES 4.1%
REPUBLIC OF HUNGARY 4.1%
BRAZIL-GLOBAL BD BRAZIL 4.1%
REPUBLIC OF PAKISTAN 4.0%
REPUBLIC OF KOREA 4.0%
REPUBLIC OF URUGUAY 4.0%
Then consider which list gives most exposure to the fastest growth in the emerging markets world. Consider another point: the potential for capital gains in emerging markets bonds is limited: the total return comes from any fall in interest rates and the current yield. Considering that the yield spread over treasuries this year has declined from 1200 to 400 basis points (12% to 4%) over treasuries it would seem the potential for more capital appreciation in emerging market bonds is limited. By contrast the potential for gains in emerging markets stocks is not capped in the same way. While this year's returns are not a predictor of the future the relationship between the emerging markets stocks and bond etf returns this year is instructive. In a boom year for flows into emerging markets the ishares emerging markets bonds etf (EMB) is +26.84% the powershares emerging bond etf (PCY)+36.18% and the ishares stock etf is +68.84%.
The WSJ in a recent article on emerging mkt bonds displayed a chart showing the growth of $100 in emerging market bonds since 1994. It indeed looks impressive. I then ran a chart for emerging markets stocks based on growth of $1 over the same period (just multiply by 100 to get the exact comparison) the bond chart is the insert the larger chart is for stocks. Over the period $100 invested in emerging markets bonds would have grown to $500, that same $100 invested in emerging market stocks would have grown to $2400.
Another point: while there are actively managed emerging market bond funds that invest in local currency denominated bonds (with the higher fees and other negatives of actively managed funds), the emerging market bond etfs invest only in dollar denominated bonds. Therefore unlike emerging market stock etfs the bond etfs do not give currency diversification.
Finally the yield pickup: as noted the yield spreads of emerging market bonds vs US treasuries have narrowed tremendously this year. As noted, this means that both the potential for further capital appreciation is limited and the yields have dropped considerably for the PCY the current yield is 6.29% for the emb it is 5.11. Given the credit risk associated with emerging market bonds it would seem to me those looking for yield pickup might be better served looking at US high yield corporates the ishares HYG is still yielding 8.95%. The comparable treasury etf yield is 2.76%. Of course the yield spreads on the US high yield bonds have narrowed tremendously yielding a total return this year of 36.99%. Potential for future capital gains are probably limited and there is certainly credit risk here as well but at least the yield differential is more attractive.
So while I am a big advocate of international diversification in portfolios with a significant allocation to emerging markets, in my view the case for stocks far outweighs the case for bonds.