Emerging market bonds are positioned between investment-grade corporate bonds and high-yield bonds on the risk-reward scale. As a result, emerging market debt should be viewed as a longer-term investment that is not ideal for someone whose primary concern is capital preservation.
Is it wise to invest in developing market bond funds?
Fixed income debt issues from developing countries are included in an emerging market bond exchange-traded fund (ETF). Government and business bonds from Asia, Latin America, Africa, and other parts of the world are among them. Emerging market bonds often yield higher returns than traditional bonds for two reasons: they are riskier than bonds issued by more developed countries, and developing countries grow quickly.
Is investing in emerging markets risky?
- Since their inception in the early 2000s, emerging markets have remained a popular investment region.
- While investors who can identify the correct emerging market investment at the right moment stand to win a lot of money, the hazards are often underestimated.
- The road to becoming a developed economy isn’t always smooth, and when countries encounter political upheaval or natural calamities that severely (and unexpectedly) stifle economic progress, it can be costly to eager investors.
- When fundamental prudence is applied, the benefits of investing in an emerging market can outweigh the dangers; the fastest-growing economies will have the highest growth and best-returning equities.
What are the dangers of emerging market bonds?
- There is a political risk. Governments in emerging markets may be unpredictable, even volatile. Political turmoil has the potential to harm the economy and investment.
- Risk to the economy. Inadequate labor and raw supplies, rapid inflation or deflation, unregulated markets, and faulty monetary policies are all common problems in these markets. Investors may face difficulties as a result of all of these issues.
- There is a currency risk. When compared to the dollar, the value of emerging market currencies can be exceedingly volatile. If a currency devalues or falls dramatically in value, any investment benefits may be reduced.
Is Emerging Market Debt a Risky Investment?
We talked about the appeal of emerging market (EM) stocks last week. Let’s move up the capital structure this week and take a closer look at EM debt. In comparison to equities, bonds are generally thought to be a safer investment. Bondholders get predetermined interest payments throughout the bond’s life and a principal payment at the bond’s maturity. With interest rates in the United States and other developed markets reaching historic lows, bond investors have forced to broaden their horizons in quest of current yields. Bonds issued by emerging market countries and enterprises are a viable option.
These bonds typically provide higher yields than their developed market equivalents; however, investors should be aware of the market’s underlying issues. EM debt offers diversification and the possibility for a better yield than standard fixed income investments. However, in the near future, it may find itself in the crosshairs of some of the developments taking place in the United States.
What Drives EM Debt Performance?
Risk assets benefit from the global economic recovery. EMs are seen as riskier investments than developed markets, and flows into EM assets tend to reflect global risk sentiment. When there are mounting hazards on the horizon, such as the pandemic last year, investors’ first inclination is to protect their cash, so they avoid riskier investment destinations like emerging markets. When economies recover, though, capital begins to move more freely. Consumers are willing to spend, businesses are willing to invest, and investors are willing to lend to or invest in consumers and businesses that are willing to spend. Investors are also more confident in committing their cash outside of their home country to take advantage of economic improvement elsewhere. This is what we’re seeing now, as economies rise from the pandemic’s shadow. The worldwide manufacturing Purchasing Managers’ Index has risen above its historical norm, indicating a tentative economic rebound. This is good news for emerging market debt. If the current economic trend continues, global capital flows into emerging markets may continue to increase.
Underpinnings that are solid. For numerous reasons, emerging market debt is regarded riskier than developed market debt. EM countries’ fiscal and monetary conditions are often more fragile than those of developed market countries. It doesn’t take much to make people unstable. EM sovereigns and enterprises have defaulted on their debts on multiple occasions in the past, and they frequently require outside assistance to handle their affairs. Is it worth risking our cash in some of the world’s poorer regions, which are less able to handle the pandemic, with the pandemic still devastating economic havoc in many parts of the world?
Let’s take a look at what happened in 2020. Last year, almost every country had to borrow money to cover pandemic costs. EMs were no exception. The average debt-to-GDP ratio for emerging markets increased from 48% in 2019 to 60% in 2020. However, even with increasing borrowing, debt servicing expenses did not rise significantly due to falling interest rates around the world. A lower mortgage rate allows us to buy more house for the same monthly payment when purchasing a property. EMs, likewise, were able to borrow more without straining their budgets. This helped them cope with the economic downturn during the pandemic and will continue to do so for years to come. The IMF’s emergency financing initiatives allowed some countries to take advantage of them. A few outlier countries with the worst credit ratings restructured or defaulted on their bonds. Overall, the worst in terms of credit risks in emerging markets may be behind us, and the future may be considerably brighter.
The appeal of diversification. One of the most appealing features of EM bonds is their low correlation to most other investments held by US investors. Because they have a low correlation, they may not be affected by market forces in the same way as the other assets in the portfolio. As a result, including EM bonds in your portfolio can help you achieve your goal of having a diversified (“all-weather”) portfolio.
Rising interest rates in the United States make EM debt less appealing. The greater yield offered by these investments is one of the primary drivers of flows into EM debt. In a world where yield is scarce, investors have turned to emerging market debt for the promise of better returns. Of course, higher-yielding assets are not without risk, since both sovereign and corporate EM debt securities have a higher level of risk. Interest rates in the United States have risen since last year’s lows. The yield on a 10-year US Treasury note was as low as 0.5 percent in summer 2020 and has since more than tripled. As interest rates in the United States climb, investors will be less willing to take on the higher risk of EM borrowers.
The direction of the dollar is significant. When risks rise rapidly, the dollar is seen as a safe-haven asset and a place to shelter. This happened in March of last year, leading the dollar’s value to climb rapidly and massively against other currencies. Since then, the dollar has fallen due to positive vaccination news and signs of economic revival. However, since the start of 2021, it has increased marginally as the US economic outlook has brightened and interest rates have climbed. This has implications for EM debt. A stronger dollar signifies a lower value for EM borrowers that borrow in US dollars; as a result, they must make loan payments with more of their own currencies. The direction of the dollar may not have a direct influence on local currency EM borrowers. A higher dollar, on the other hand, means that a local currency EM loan payment gets translated back into fewer dollars for an investor.
Is the Higher Risk Worth It for Investors?
We all know that emerging market debt is riskier and so pays a higher yield. But how much more does it pay in terms of yield? The spread, or excess yield, of an EM bond over a Treasury bond of comparable maturity is used to determine this. EM yield spreads blew up when the markets were paralyzed in March 2020. In other words, for speculating on the EM borrowers’ limited ability to pay, investors sought a considerably higher rate. Investors regained faith in the ability of EM borrowers to repay their obligations as countries and enterprises rebounded from the lows of 2020. As a result, their appetite for greater spreads has dwindled, and EM debt is currently trading at spreads that are close to historic averages. In other words, they are valued at a level that is comparable to historical averages. Keep in mind that we are far better off now than we were in March 2020. Vaccinations are rising up over the world, indicating that the pandemic is nearing its end. Consumers and corporations are spending again as economies rebound. Earnings are on the mend. EM bonds, on the other hand, have less possibility for upside at current values, even though they are sensitive to risks of recovery derailment.
Beware of Near-Term Risks
The post-pandemic global rebound will boost emerging market bonds. Despite the economic chaos induced by the epidemic, the EM debt universe has stronger foundations today. Its diversified growth drivers provide traditional portfolios with diversification benefits. In a low-rate environment, it provides the possibility to earn a greater yield to suit investors’ income demands. However, it is vulnerable to erratic capital flows, rising US rates, US currency consolidation or prospective strengthening, and narrow spreads or wealthier values in the near term. EM bonds are an asset class that necessitates a hands-on approach, as well as a tolerance for and capacity for higher volatility. It necessitates a broader understanding of the asset class’s macro determinants of risk and return, as well as a long time horizon.
The Purchasing Managers’ Index (PMI) is a measure of the manufacturing and service sectors’ current economic trends. Because of variations in accounting techniques, international taxation, political instability, and currency fluctuation, emerging market investments may carry more risks than developed market investments.
Note from the editor: This piece first appeared on the Independent Market Observer.
What is the meaning of emerging bond spreads?
Introduction. The interest rate spreads that emerging market economies pay to borrow in international financial markets over US Treasuries known as EMBI spreads1 are a measure of their financial fragility and vulnerability as well as their costs of funds.
Is equity financing more important in emerging markets than debt financing?
-In emerging markets, equity financing is preferred over debt financing. The majority of foreign exchange and bond trading takes place on a trading exchange. Corporate (nonfinancial) bond issuance is lower than government bond issuance. – Cross-border trading between corporations accounts for the vast majority of FX transactions.
Is it wise to invest in emerging markets in 2022?
Emerging markets are better equipped to deal with COVID-19 in 2022 than they were a year ago. After a post-pandemic surge, economic growth is declining due to a downturn in China and stricter monetary and fiscal policies abroad. If inflationary pressures diminish, we anticipate policy tightening will follow.
Is investing in emerging markets a good idea in 2021?
In 2021, the majority of equity funds focused to investing in emerging markets performed poorly. In the current year, these funds have generated negative returns on average. The benchmark MSCI Emerging Markets index is down more than 6% year to date, compared to an 18.31% increase in calendar year 2020.
How much of my portfolio should be invested in emerging markets?
However, you may already be involved with emerging markets in an indirect way, even if you aren’t aware of it. They’ve been a staple of many long-term, diversified stock and bond portfolios, particularly ones comprised of low-cost index funds, over the last 20 years or more.
They account for over 12% of the MSCI ACWI Index, the most important benchmark for global stock investing. (Countries deemed too impoverished, illiquid, unregulated, state-controlled, or otherwise troubled to qualify as emerging or developed markets are excluded from the index.)
When you consider that emerging countries account for around 39 percent of global GDP and nearly a quarter of the value of global stock markets, this benchmark allocation isn’t particularly large. Morgan Stanley has also determined that a 27 percent emerging market allocation in a global stock portfolio delivers the optimal risk-return balance using modern portfolio theory assumptions.
Apart from short-term market gyrations, there are several valid reasons to avoid investing extensively in emerging markets: You will be investing in political and economic systems that you may find unappealing, if not downright evil.
With all of its laws and regulations, convincing public corporations to perform responsibly is challenging enough in the United States. Through proxy votes and other initiatives, people having an indirect investment in American corporations through mutual funds are only now beginning to be able to exercise their shareholder rights.
Shareholder rights movements in authoritarian nations like China and Russia, to name two famous examples, are currently futile. As a result, limiting emerging market allocations makes sense. And putting money into so-called E.S.G. funds funds that attempt to avoid investing in companies that do not match fund standards in terms of environmental, social, and governance seems like a good idea.
Such screening is done by some index funds. The iShares ESG Aware MSCI EM ETF, the SPDR MSCI Emerging Markets Fossil Fuel Reserves Free ETF, and the Vanguard ESG International Stock ETF, which invests in both developed and emerging markets, are a few examples. Actively managed funds, which have substantially higher fees, also accomplish this. Goldman Sachs’ GS ESG Emerging Markets Equity Fund and JPMorgan Funds’ Emerging Markets Sustainable Equity Fund are two of them.
Why should you stay away from emerging markets?
Emerging markets must issue bonds with higher interest rates since they are considered riskier. The increased debt burden raises borrowing costs even more, increasing the risk of bankruptcy. Nonetheless, this asset class has shed most of its risky background.