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Income-starved investors finding higher income in emerging market bonds

With interest rates at record lows in North America, investors seeking higher fixed income returns are heading in droves to emerging market (EM) bonds – abandoning low-yielding traditional income producing instruments such as guaranteed investment certificates, treasury bills and Canadian government bonds.

And the reason is simple. Emerging market bonds have provided significantly higher returns since the end of the 2007-08 global financial crisis, meeting the needs of income-starved investors. EM bonds are issued by governments and corporations of emerging market countries in either US$, Euros or in the local currency of the issuing country.

Currently at US$14.5 trillion, the universe of emerging market bonds represents approximately 12% of all bonds issued. It is relatively liquid and growing at a rapid pace. With more than 60 different countries issuing bonds, investors have exposure to different countries and regions with varying economic conditions – providing them with access to a geographically diversified universe of bonds.

But higher returns and geographic diversification are not the only reasons why investors are finding EM bonds attractive. EM bonds also have a low correlation to other asset classes, such as equities and other fixed income instruments, meaning that their values do not move in sync with these asset classes amidst varying market conditions. They can therefore be used to reduce the risk and volatility of their portfolios.

Incidentally, higher emerging market bond yields are based on fundamentally sound economic reasons. Emerging markets are on average growing more than twice as fast as developed markets, like Canada and the United States. Higher growth has in turn led to higher inflation which is kept in check by higher interest rates.

David Kunselman, senior portfolio manager with Mississauga-based Excel Investment Counsel, manager of the Excel High Income Fund which invests in emerging market bonds, believes that the “demand for emerging market bonds will continue to grow as more and more investors recognize that traditional fixed income investments are not meeting their income needs.”

For instance, he says, “current Government of Canada 3 – 5 year bonds are yielding below 2%, whereas the Excel High Income Fund pays out an annual distribution of 6%.”

A September, 2014 Bank of America Merrill Lynch report recognizes the flight to emerging market bonds, noting: “Since the summer of 2013, there have been heightened concerns about the implications of tapering and rising developed market rates for EM local bond performance. Despite this, we have seen consistent inflows into local markets, picking up even more heavily in 2014. As a result, foreign investors have become a significant portion of the investor base in many local debt markets.”

The truth is, says Kunselman, “emerging markets are now much more creditworthy.” The risk premium of emerging markets debt has declined significantly in recent years, resulting in significant improvements in the credit ratings of EM bonds. Currently, over 64% of EM bonds are rated investment grade, compared to about 20% in 2000.

The debt-to-GDP ratios of emerging markets have also fallen dramatically since the turn of the century, giving emerging market policymakers greater flexibility to implement fiscal and monetary policies. For instance, the government debt-to-GDP ratio of emerging markets is on average about 35% compared to about 100% for developed markets. Incidentally, higher debt has been a drag on the economies of developed countries and is a significant contributor to their lower economic growth.

Kunselman suggests that the increasing attractiveness of emerging market bonds is also due to the fact that a greater portion of bonds are being issued in local currency. Traditionally, most emerging market bonds were denominated in either the US$ or Euros. However, that has changed in recent years with the majority of new EM bonds being issued in the currency of the issuing country.

The shift to issuing debt in local currencies has resulted from improved credit ratings of emerging countries; significantly higher economic growth; substantially lower debt levels; and much higher foreign reserves – resulting in EM countries becoming less dependent on external currencies. Incidentally, bonds issued in local currency are not susceptible to swings in the US$ or Euro, reducing currency risk for investors.

According to Kunselman, the risk of default by emerging market countries is also very low. EM governments have learned valuable lessons from the sovereign debt crises and currency devaluations of the mid-to-late-1980s and have since adopted prudent monetary and fiscal policies which have made their economies much more stable. They are experiencing strong economic growth, introduced flexible currency exchange rates, accumulated vast reserves of foreign currencies and reduced their debt levels. These structural improvements in their macro conditions have improved their creditworthiness, lowering the risk of default.

Evidently, emerging market bonds are becoming the choice of investors seeking higher yields which they can no longer get from traditional fixed income instruments.

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