The case for emerging market debt

For the past 10 years, emerging markets bond funds have posted annualized returns of 9.54%, topping all bond fund categories tracked by Morningstar, by a large margin. (High-yield bond funds were second, with 8% annualized returns.) Is emerging market debt still an attractive asset class, or is a correction likely to squeeze investors?
“We think that having a portion of an investor’s overall bond allocation in emerging markets bonds still makes sense,” says Lisa Brown, a partner at Brightworth, an Atlanta-based wealth management firm. “Many emerging markets have stronger growth prospects and less debt than most developed countries, which is appealing for bond investors.”
Brightworth partner and director of portfolio management Don Wilson spells out some of the reasons for continued optimism. “The asset class has matured over the last decade,” he says. “The credit rating for emerging market debt has improved and spreads to U.S. Treasuries have come in. Given the loose monetary policies of many developed countries, emerging nations have the potential to benefit from a stronger currency as well.”
Richard Lawrence, senior vice president and director of institutional client service at Philadelphia-based investment management firm Brandywine Global, says that emerging markets debt valuations have become “lofty,” but he still sees opportunities there. “Most global growth is now coming from emerging markets,” he points out, “and fiscal fundamentals in those countries have improved. Twenty years ago, only 2% of emerging markets debt issues were considered investment grade. Now that percentage is around 60%.”
Nevertheless, emerging market debt is not without risk. “In 2008, for instance, the Barclays Emerging Market Debt Index was the second worst performer within fixed income sectors, down 14.7%,” says Wilson. Thus, investors need to understand the volatility of the asset class, have reasonable return expectations, and a long time horizon. Brown adds, “We believe emerging market bonds make sense in the long term but, in a flight to quality, we would expect emerging market bonds to sell off more than most other bonds.”
Advisors interested in emerging markets bonds can use a manager focused on this asset class or a broader-based manager who can rotate in or out of emerging markets issues. Craig Carnick, president of Carnick & Kubik, a Colorado Springs-based financial advisory firm, says that emerging markets bond funds play a role in his firm’s income strategy.
“Our current approach to income,” Carnick says, “includes holding individual U.S. corporate bonds; dividend-paying stocks; and around 20% in alternatives such as MLPs (about 5%), emerging market debt (8%), a strategic income fund (5%), and a limited term income fund (2%). Carnick’s 8% allocation to emerging markets debt is split between TCW Emerging Markets Income Fund and Transamerica Emerging Markets Debt Fund. According to Carnick, with this approach the foreign debt risk component is buffered by the other parts of the portfolio.
Brightworth, on the other hand, participates in emerging market debt through a global bond manager who invests in U.S., developed international, and emerging international bonds. “We utilize the PIMCO Global Advantage Strategy Bond Fund for this role in our portfolios,” says Brown, “which is one part of our clients' overall bond strategy.”
Lawrence also sees the advantages of using global bond managers, who have flexibility about an allocation to emerging markets debt. “There were times during 2011 when global growth was slowing,” he says, “and the euro zone faced a severe crisis. Emerging markets debt did poorly, but emerging markets bond managers had nowhere to hide. A global manager could move into bond markets such as the U.S. and the U.K., which weren’t as exposed.”
Currently, Lawrence has over 50% of his global fixed income portfolio in issues from countries that bridge the gap between emerging markets and the developed world. He is especially upbeat on Mexico; he also puts Malaysia, Poland, and South Africa in that category. “These countries may have relatively small economies,” he says, but they also have large bond markets with strong liquidity and no barriers to foreign investment.”