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Tuesday, May 4, 2010

Emerging Market Bonds During a European Economic Crisis (or pretty much any othe time)?....No Thanks

 Two major international bond managers have been touting their heavy weighting of emerging market bonds in their global bond portfolios. Count me as skeptical of using these as part of any investors bond asset allocation.

In a previous post I wrote about the Templeton bond fund, praised in the WSJ for "thining different" in the words of the iconic Apple computer commercial.

Pimco, the bond powerhouse has also been aggressively promoting a bond fund with a heavy allocation to emerging markets.

Pimco launched its Global Advantage Bond Fund this year based on the index it created in 2009. The fund is listed on their website as a core bond holding and has a 30% weighting in emerging markets markets.

In fact larger holdings in emerging markets has emerged (pun intended) as a key part of their fixed income strategy. The WSJ reported

my bolds my comments from here on in blue

Pacific Investment Management Co., the world's biggest bond-fund manager, is increasingly investing in emerging-market corporate debt, part of a broader move to ramp up exposure to the fastest growing economies in the world and assets with the highest returns.
Pimco's clients, including pensions funds and insurance companies that are often the slowest to warm to the developing world, have progressively expressed more interest in this group of bonds, said Ramin Toloui, an emerging market portfolio manager at Pimco's Newport Beach, Calif., office. He was speaking via telephone en route to Washington for the International Monetary Fund's spring meetings.
Pimco, a unit of Allianz SE, has overall identified emerging markets as a growing opportunity, and last month increased its benchmark Total Return mutual fund's exposure from 5% to 6%.
However, the launch of Pimco's Global Advantage Bond Index last year is indicative of how much Pimco thinks investors should be exposed, said Mr. Toloui.
That index has a 30% allocation in emerging markets, he said.
Pimco has a research paper that makes the argument for the high weighting emerging markets vs developed and thus using a gdp weighted as opposed to cap weighted index as the basis for a portfolio. The arguments are familiar by know: large budget deficits in the developed world, questions on sovereign creditworthiness in other words Greece(and spain and portugal)  are just the beginning .
And unlike the 1990s and early 2000s theconditions in the emerging world in terms of macro economic conditions are better. Fair enough if one is venturing into international bonds it makes sense to weigh emerging bonds more heavily than indicated by a cap weighted bond index.

Also not surprising Pimco is able to trot out data showing that a heavy weighting in emerging market bonds increases returns without increasing risk..

Just as might be the case for emerging market bonds, high yield bonds may at times provide higher returns than the holdings on the bucket/umbrella side of the portfolio. But when I manage portfolios I hardly look at that lower return as an opportunity loss. I would compare the emerging market bonds to the rest of the risk assets in terms of risk total return and the diversification they provided.

Furthermore in terms of rirks protection we know that in times of crisis all risk assets become correlated and moved down. We saw this with emerging market bonds and stocks in 2008. There is little doubt in my mind that if a major capital markets crisis occurred again emerging market sovereign debt will perform worse than tresury bills.

I think we have seen this before. Researchers give a strong case for emerging markets outperforming other parts of the world based on stronger fundamentals and assume that past data on correlations and risk and return that the portfolio with a heavy weight to emerging markets will behave in the futures as it did in the past.

In fact it is quite likely that if there is a severe crisis anywhere in the financial markets emerging markets fixed income will suffer along with the rest of the world. and that the only safe haven will be in US treasuries. It certainly seems that way based on the 2 most recent major crises,

In August 1988 Russia defaulted on its bonds but the contagion spread across emerging markets, Emerging markets bonds fell 28% US govt bonds +2.6%

In the most recent crisis with minimal fundamental problems in the developing world relative to the developed, Oct 2008 saw emerging bonds -14% the US aggregate bond index fell -.3%

In other words everything goes down in a down market except correlation...this holds for bonds and stocks.

In the wake of the 2008 crisis there has been alot of rethinking about portfolio theory and portfolio management and its limitations. Probably the most useful conclusion is as to the limit utility of diversification as commonly referred to in finance. Diversification comes from the low correlation of asset classes a measurement of how much assets/asset classes move togehter. According to theory adding assets with low correlation to each other to a portfolio offers the potential for increasing return without increasing risk. But experiences shows that it is very often not the case, particularly in times of financial stress.

Diversification is not the same as risk management. It is undeniable from looking at the data that correlations go up during sharp market declines. In other words the kind of diversification that one might hope for based on statistics with regard to correlation fades away just when one needs it the most. Mark Kritzman of MIT and Windward Capital has written about the Myth of Diversification. He has pointed out that most people in the real world look at "good correlation and bad correlation" good correlation being assets that offer protection during a down market and bad correlation assets that pull down returns when the overall market is rallying. He akins the conventional way of looking at risk management through correlation to someone putting their head in an oven and their feet in a bucket of ice in order to create a moderate body temperature.

I agree completely and therefore only view the safest fixed income strictly defined as tbill asn tips and a hedge with an asymmetic payoff such as long puts and long volatility as risk reducing diversifiers.

A portfolio with a high weighting of emerging market bonds certainly does not fall into this category it is simply adding to the risk asset side of the portfolio.

 I agree with most of the arguments for long term outperformance in the emerging markets and have positioned the equity allocation of my portfolios accordingly. But I dont find the argument for emerging market bonds as an addition or alternative particularly convincing. First of there is minimal debt to be had from some of the fastest growing emerging economies, judging by the list of countries in the FTs table of emerging markets Singapore, Hong Kong, China and India have minimal outstanding bonds. In fact despite all the publicity and literature surrounding the fund and the growing parts of the emerging economies a review of the portfolios holdings on the website shows less than 1% of holdiing in remimbi bonds, nothing from India, Singapore or Hong Kong (but plenty of holdings in Europe, Mexico and Brazil)..Obviously this is far different than the country exposure one would structure with equity etfs or even active funds if one's investing thesis woas to position to participate in the high economic growth in emerging markets and emerging asia in particular.

As a consequence of the fact that there are virtually no bonds to buy from the fastest growing emerging asian. For that reason the Pimco bond fund takes outright currency positions in order to get exposure to China , South Korea and Taiwan. The rationale is expressed below. But since the chinese currency is no freely exposed to market conditions the chinese yuan positions amounts to a bet on future government policy. Sorry but I would rather be directly exposed to the economy's growth through equities.

Pimco is pushing this idea of emerging market bonds across its products. Another fund the Pimco Unconstratined Bond Strategy which can hold up to 50% emerging markets also ventures into this area but winds up with slim pickings in emerging asia debt and instead looks to outright currency positions.

from Pimco:

On the currency front, we are long a basket of Asian currencies, anchored by the Chinese yuan and with satellite positions in the South Korea won and Taiwan dollar. We believe these regions’ currency appreciation is a natural response to the fundamental need of China to shift from an export-oriented toward a more consumer-led economy. The Asian region has fared relatively well recovering from the latest bouts of global recession, and has the resources, labor force and rising total factor productivity that we believe will lead to a currency correction. We also hold positions that may benefit from expected weakness in the British pound and euro currencies.

Secondly the yield spreads are so minimal as to offer extremely limited risk return vs US bonds the highest yielding asia bond was indonesia 1t less that 2% over treasuries ...and there is certainly potential for political instability there. I would much rather hold emerging market stocks for my emerging portfolio and  if I were to put any fixed income on the risk side of the asset allocation do it through a purchase of a liquid high yield US dollar instrument like the HYG with a yield differential of well over 4.5% over treasuries.

A bond fund is in fact a very poor way to try to get a benefit from the growth in emerging markets.

In my view the new  products that incorporate large allocations to emerging markets bonds are a classic case of a "product" that has to be "sold" as opposed to a financial instrument that actually makes asset allocation cheaper and better.

Interestingly in an interrview on the pimco website  Lisa Kim one of their managers states the following:

In thinking about where this strategy fits in an investor’s asset allocation, consider why investors buy bonds in the first place. Typically, they are looking for (1) capital preservation, (2) diversification from equities, (3) income, (4) liquidity and (5) impact mitigation from an economic downturn. A core fixed income strategy and the Unconstrained Bond Strategy should really be no different in how they address each of the first four concerns.
the manager furthermore argues that in an inflationary rising rate environment their fund would do better than a standard bond fund

My response to the Pimco manager would be "maybe yes and maybe no" especially since the investor has no idea what the fund owns at any given point in time.

On the other hand I love the economic/scientific term occam's razor thks to wikipedia for this 

law of economy or law of succinctness). When competing hypotheses are equal in other respects, the principle recommends selection of the hypothesis that introduces the fewest assumptions and postulates the fewest entities while still sufficiently answering the question.. 

So if I were to refer back to the quotation above from Ms. Kim on why investors hold bonds and would be faced with the choice of:

a. A pimco actively managed portfolio that could contain foreign currency, emerging market bonds, mortgage backed securities, corporate bonds, taxable munis like the Unconstrained Bond Fund, the Global Advantage Bond Fund or even the flagship Pimco Total Return Fund


b. a mix of tbills and US Tips

It seems pretty self evident where occam's razor would point me

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