The Emerging Market Opportunity In A Yield Drought

yieldYou have to cast a wider net for income in a low yield environment. Heidi takes a look at the case for emerging market bonds.

ekkaluck sangkla / Shutterstock

ekkaluck sangkla / Shutterstock

Thanks to lackluster global growth, and rock-bottom interest rates in the United States — and even negative rates in other parts of the world — investors face the choice of either accepting lower income or increasing risk in their bond portfolios in the search for yield. One asset class worth considering: emerging market (EM) bonds.

Less than 10 years ago, investors could turn to simple U.S. Treasuries to achieve a 4% yield, according to Bloomberg data. But after the 2008 financial crisis, central bankers around the globe significantly lowered interest rates to stimulate growth, dropping real yields close to zero for high quality debt. In this environment, the opportunity for investors to save and plan for the future became more and more challenging.

With 10-year Treasuries yielding less than 2% today (from Bloomberg data), investors unwilling to accept such low income may need to direct their investments across riskier assets in the search for yield. Income-seeking investors may need to consider exploring riskier areas of the bond market like high yield and EM bonds.

But besides the level of yield, fixed income investors should also look at an investment’s level of risk. While many today are focused on the next rate hike in the United States, there are other risks beyond interest rate risk, namely credit risk.

Credit risk is essentially the risk that an issuer will not be able to support coupon payments or be able to pay back principal. In general, bonds are divided into two broad levels of credit quality — investment grade (IG) and high yield (HY).

Where does EM debt fit into the picture?

Typically, somewhere in the middle because the EM bond universe contains both IG and HY bonds. According to Bloomberg, as of June 15, 2016, more than 60% of the issuers in the iShares J.P. Morgan USD Emerging Markets Bond Index are rated investment grade. The asset class represents a combination of corporate and sovereign issuers.

As an asset class, moreover, EM debt has changed substantially over the past decade and become increasingly higher quality. Ten years ago, roughly 30-40% of the issuers in the index were investment grade, according to Bloomberg data. As the International Monetary Fund has reported, many EM economies have experienced solid economic growth, stronger balance sheets and reserves accumulation, improving some governments’ ability to pay back their debts. Still, it is worth noting that many emerging markets face enormous challenges, as we have seen recently in Brazil, for example. Nonetheless, overall EM fundamentals have improved in general.

In an increasingly low-yield world, emerging markets potentially offer competitively high yields. As an asset class, EM bonds have rebounded in 2016 with the JP Morgan EMB Core Index up 8.33% this year (as of 6/17/2016, according to Bloomberg) versus a 0.81% return in 2015. Many headwinds from last year dissipated and even turned into tailwinds. These include a U.S. dollar that has weakened since its 2015 rally and stabilizing commodity prices.

Looking forward, it will be important to watch the outlook for global growth in both emerging and developed markets, the continued pace of Federal Reserve hikes, the trajectory for the dollar and the prospects for commodity prices.

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