Emerging-markets and high-yield bonds have delivered stellar returns over the past decade.
Does that mean that advisors should use these investments to spice up clients’ fixed-income allocations?
Through May 14, Morningstar’s intermediate-term bond category posted annualized 10-year returns of 3.8%. Meanwhile, the emerging-markets bond and high-yield fund categories solidly topped that number, at 5.9% and 6.3%, respectively.
In the market turmoil of early February, emerging-markets and high-yield bond funds showed their volatility by falling more than intermediate-term bond funds, but the numbers indicating 10-year superiority remained virtually unchanged.
Given that record through a bust and boom, it isn’t surprising that these funds are attracting considerable attention.
Many advisors favor either or both.
“Emerging-markets bond funds and high-yield bond funds provide diversification to the traditional stock and bond components of our clients’ portfolios,” says Kelly Henning, an advisor at Modera Wealth Management in Westwood, New Jersey.
“One of the current concerns surrounding U.S. investment-grade bonds is increasing interest rates,” she says. “Emerging-markets bonds are not directly exposed to the U.S. interest rate environment, so they are a welcome addition to our clients’ bond allocations.”
Not everyone is jumping on the bandwagon, though.
“In fixed income, my emphasis is on capital preservation,” says Timothy Hayes, founder and president of Landmark Financial Advisory Services in Pittsford, New York.
“Therefore, I don't like the sovereign and/or credit risk that comes with emerging-markets bonds and high-yield bonds,” he says. “Typically, I don't typically follow them, recommend them to clients, or buy them myself.”
Weighing the Tradeoffs
Henning cites several other positives to emerging-markets bonds, as well.
Developing nations tend to have lower debt-to-gross domestic product ratios and stronger growth potential than developed countries, she says.
And though, yes, emerging-markets bonds may be riskier than their investment-grade counterparts, Henning says that they also tend to compensate clients with higher returns.
“The potential downside of high-yield bonds was readily apparent during the credit crisis, when those funds declined over 20%,” Henning says.
In 2008, amid that crisis, emerging-markets bond funds lost 18%, high-yield bond funds lost 27%, and large-blend stock funds fell 38%, in sharp contrast with intermediate-term bond funds, which declined just 5%.
But emerging-market and high-yield bond funds also come with higher payoff potential.
In the 2009 rebound, for example, these funds roared back with a vengeance. Emerging-market funds gained 32%, and high-yield funds were up 46%, whereas intermediate-term bond funds and large-blend stock funds posted smaller gains of 13% and 28%, respectively.
Portfolios at Modera Wealth Management often have a total 10% to 30% allocation to these categories. For example, a client with a 60-40 allocation, stocks to bonds, might have as much as 12% of the overall portfolio in emerging-markets debt and high-yield bonds combined.
“This allocation helped to bolster investment-grade bond returns over the past two years, but adding funds beyond 30% could meaningfully detract from the performance and raise the risk level of the portfolio,” Henning says.
“These two asset classes have had two years of strong performance accompanied by bond spread compression,” she says, referring to how strong demand for lower-quality bonds has led to lower yields. “As a result, there’s a need to keep an eye on the risk/return attributes of these funds and be careful about further investments.”
The recent strength of both bond categories has prompted Modera Wealth Management to review those holdings.
“To maintain our targeted risk level, we decided to reduce our exposure to the lower end of the 10% to 30% range,” Henning says. “Spread compression has produced lower expected returns.”
Some advisors use emerging-markets funds but not high-yield ones.
“We believe that emerging-markets bond funds provide good diversification within a bond portfolio,” says Diahann Lassus, president and co-founder of Lassus Wherley, a wealth management firm in New Providence, New Jersey, and Bonita Springs, Florida. “Yields continue to be reasonable — about 5% from the fund we mainly use — and the returns have been good for the risk investors take.”
Emerging-markets funds may hold local-currency bonds, dollar-based debt or both.
“The fund we tend to use is U.S. currency based, so we have some concerns around the weak dollar,” Lassus says.
“However, we are long-term investors and are not as focused on short-term movement,” she says. “There is definitely a need to diversify bond portfolios outside of U.S. fixed income and the emerging-markets area can add value, at a slightly higher risk.”
That said, Lassus is more cautious about high-yield funds.
“We don’t use high-yield funds specifically,” she says. “We do use funds that may allocate their holdings across several different bond sectors, including some percentage in high yield.”
Spreading the Risk
“I am a big believer in diversification,” says Sheryl Rowling, head of rebalancing solutions for Morningstar and a principal at Rowling and Associates, an advisory firm in San Diego.
When she considers any potential portfolio addition, it must meet one of the following three criteria: it increases return without increasing risk; it decreases risk without decreasing return; or it increases return and decreases risk.
Emerging-markets bond funds pass the risk/returns test and merit a small allocation in clients' portfolios, Rowling says.
But she is not a believer in high-yield bonds.
“In today's environment of low interest rates, many investors chase returns by moving to lower quality,” Rowling says. “I would not cross the line into junk bonds, because I believe the risk outweighs the potential benefit.”
Rowling’s aversion does not apply to municipal high-yield funds, however, which “are not close to junk,” and thus may merit a place in client portfolios, she says.
A similar line is drawn by Glenn Frank, director of investment tax strategy at Lexington Wealth Management in Lexington, Massachusetts, who includes emerging-markets funds and muni high yields in clients’ portfolios but excludes high-yield funds owning taxable bonds.
“I would not invest in high-yield corporate bonds today,” he says.
“High valuations make them risky. To make matters worse, they have relatively high correlation with U.S. equities, which are risky enough by themselves, given their lofty valuations,” Frank says.
Frank also cautions on traditional fixed-income positions.
“Core fixed income is low-yielding today, with some risk,” he says. “It may be better to use higher-yielding fixed-income categories that behave differently from each other, so the group as a whole isn't that risky, yet still gets better yield than core fixed income.”
Thus, Frank opts for preferred stock and bank loan funds, along with high-yield munis.
“They are better choices for yield, with lower correlations to stocks,” he says.
“With this approach, about half of a fixed-income allocation might be in unusual holdings while the other half is in core fixed income. Our core now has a healthy dose of Treasuries as a hedge, in case of a flight to quality during a possible drop in equities,” Frank says.
Where do emerging-markets bond funds fit in his outlook?
“Emerging-markets debt correlations with U.S. equities are not quite as high as is the case with high-yield corporate bonds,” Frank says.
“In addition, emerging-markets debt valuations are not as high. Therefore, I would pick emerging markets over high-yield corporate bonds,” he says.
Emerging-markets bond funds may have fairly high ordinary income yields, generating steep tax bills in taxable accounts, so Frank favors holding them in retirement plans.
One question that arises is whether emerging-markets and high-yield bond funds are really necessary, given their correlation to equities and volatility. If clients are willing to take more risk, why not just increase their equity allocation?
“It's generally fair to say that clients with … above-average risk tolerance can increase their allocation to equities, if it’s done carefully,” Hayes says.
That could be preferable to using riskier types of bonds, he says.
Rowling, however, doesn’t think that emerging-markets bonds and high-yield bonds should be equated to equities.
“We wouldn’t normally replace any type of bond with equities, given the difference in the risk characteristics,” she says.
“We focus on making our bond portfolio the cornerstone of the safer part of the overall portfolio, maintaining more exposure to shorter-term and lower-risk bond funds. For that reason, we invest only a small percentage in emerging markets bonds,” Lassus says.
This story is part of a 30-30 series on evaluating fixed-income opportunities when rates are rising. It was originally published on Feb. 13.