Emerging markets offer income

UK income-seekers are facing the challenge of trying to ensure their investments keep pace with the cost of living. Mervyn King, governor of the Bank of England, believes UK inflation will stay well above its 2% target until 2012.

The Retail Prices Index is up 4.8% over the past year and even the Consumer Price Index, which excludes mortgage payments, is up by more than 3%.

Investors looking for high income could do worse than watch where institutional investors are heading.

For the past few months, the big boys have been flocking into emerging market (EM) bonds, which now yield around 6-6.5%, compared with returns on UK benchmark 10-year gilts of 3%, 2.64% on 10-year US Treasuries, and around 4% for investment-grade bonds in developed countries.

Further down the quality chain, emerging countries with more volatile political backdrops pay much higher annual coupons, such as Venezuela, which recently offered investors 12.75% on $3 billion (£1.9 billion) of bonds due in 2022.

Reasons for optimism

One reason for optimism is that long-term structural trends in developing Asian economies indicate strong growth.

HSBC is projecting an average growth rate of 6.9% this year and 6.2% in 2011. Within 10 years, emerging market countries will account for 50% of global GDP.

Historically, emerging markets have been associated with a risk of default but many have been upgraded by the ratings agencies. Even Uruguay, that most ropey of sovereigns, has just had its rating raised to BB-, just two notches off investment grade.

One reason for this is their much stronger balance sheets. Emerging markets have current account surpluses of almost $550 billion, according to the IMF, at a time when the debt position of many Western economies is a cause for concern.

Brazil, for example, has an approximate 60% debt-to-GDP ratio, compared with an estimated 469% for the UK during 2008.

Central banks throughout emerging markets have also become more disciplined in their monetary policy, with the focus on controlling inflation.

Buying individual emerging market bonds is difficult, however. Some broking firms stipulate a minimum of $100,000 for each bond, and bid/offer spreads are wide for small orders.

But there is a growing range of emerging market bond funds that pay dividends quarterly, and they confer all the benefits of diversification, with some holding hundreds of individual securities, ensuring a broad spread.

Returns on these funds vary. Some of the best have made around 30% in the past year. They include the Aberdeen Global Emerging Markets Bond fund.

However, EM bond funds have very different characteristics, because the sector covers many types of bonds.

Traditionally, most were issued in hard currencies such as the US dollar and the euro, but increasingly, developing countries are trying to take control of their debt by issuing it in local currency.

In a typical investment portfolio, local currency bonds offer better diversification benefits than hard currency bonds, because they are more closely aligned with their own economies, rather than US interest rates.

Fund strategy

Investors should look closely at each fund's strategy. Some are dedicated local currency bond funds, which will usually be revealed in their names as 'local currency' or 'local debt' and some are hard currency only.

There are also diversified funds, such as the fairly aggressive MFS Meridian EM bond funds, where the managers can use strategies in whatever way they think will produce the best returns.

"EM debt is a heterogenous universe," says Alexander Kozhemiakin, director of emerging market strategies at Standish, part of BNY Mellon Asset Management. 

"It encompasses three distinct asset classes - US dollar-denominated bonds, currencies, and local rates - and comprises very diverse countries ranging widely in credit quality.

"Moreover, there are two types of issuers: sovereign and corporate. As a rule, the latter tend to be less liquid. This is why it is important to be very clear about what a particular emerging market debt fund invests in, so that there is no hidden risk that investors had not bargained for."
For easy access to these assets, exchange traded funds can be purchased just like ordinary shares.

In the local bond currency arena, the Market Vectors Emerging Markets Local Currency Bond (Nasdaq: EMLC) and the actively managed WisdomTree Emerging Markets Local Debt (NYSE: ELD) pay 6-7% dividends, plus any capital gain made from currency appreciation.

For dollar-denominated bonds, the PowerShares Emerging Markets Sovereign Debt (NYSE: PCY) and the iShares JPMorgan USD Emerging Markets Bond (NYSE: EMB) yield 5.55% and 4.77% respectively. The latter is also traded in London and has a sterling version (SEMB.L).

One drawback here is that emerging market bond indices, such as the JPMorgan EMBI, are composed of nations that include the least stable, such as Venezuela, among their biggest weightings.

More recently, companies in developing countries have begun to issue corporate bonds in greater numbers, which some fund managers are also tapping into for incremental return.

However, the financial crisis highlighted weaknesses in some countries' legal systems regarding the claims of bondholders in the capital structure, particularly where companies were domiciled in the British Virgin Islands and Cyprus.

Looking ahead, the big risk to this asset class is if the economic recovery falters, which would reduce demand for commodities produced by these nations. And any move to higher US interest rates would reduce the attraction of the yields available in these regions.

But, most inflows into the sector are institutional investors buying EM debt for the first time, going from perhaps zero to 2-3%.

As such, they are structural allocations, rather than short-term tactical switches that might be reversed rapidly and create a run on the asset class in the event of another economic downturn.

"It is a mistake to believe EM is bullet proof," says Simon Lue-Fong, head of emerging debt at Pictet, which runs a fund with a £1 million minimum investment.

"Political instability remains a real issue. But central banks are inflation targeted and are operating nicely, and exchange rates are more freely floating than ever before." He has reduced his holdings in the riskier corporate issues.

Emerging market bonds should not constitute a big part of the average investor's portfolio, but a small allocation will do its bit to bridge the income gap.

This article was originally published in Money Observer - Moneywise's sister publication - in October 2010