by David Mazza, State Street SPDR Blog
Since 2010, the number of beneficiaries receiving US Social Security retirement benefits has increased 20%, while yields on investment grade rated bonds have fallen 54%.1 These demographic shifts and low interests have converged to create a definitive need for income that is not going away anytime soon.
In this type of environment, we believe emerging market debt can provide attractive yields and the potential for portfolio diversification at a compelling risk-return trade off. This allows emerging market debt to play the role of a complement to a well-diversified core as part of our Three C’s approach to building fixed income portfolios that can provide income, diversification and stability.
Risk and return in emerging market debt
Investors are generally cautious about entering the emerging market (EM) space and rightfully so. Emerging market nations can be far less stable than developed ones, with increased risk of political instability and a higher exposure to volatile commodity prices. For instance, at the start of this year, EM stocks posted three consecutive years of negative returns from 2013 to 2015 over worries of recessions in Brazil and Russia, and that slowing growth in China could hurt global trade and suppress commodity prices.2
But it’s important to understand that EM debt and EM equity are not the same. Over the past ten years, EM debt has more than doubled the return of EM equity, but with only one third the amount of volatility.3 While investors often assume that EM debt has the same risk and return profile as US high yield, that is far from the case. EM debt includes both investment-grade (IG) rated debt and below-investment-grade rated debt. More than 60% of outstanding EM debt was investment grade at the end of 2015—up from 18% in 1998.4
Source: Barclays, as of 6/30/2016. Barclays uses the "middle rating" of Moody's, S&P, and Fitch to determine a security's index classification.
When EM debt is compared with US bonds, the chart above shows that EM debt can have particularly attractive yield-to-duration measures, especially when it comes to A-rated and B-rated corporate bonds. And for a similar level of credit risk, EM debt can offer investors a much more attractive yield per unit of interest rate risk.
Emerging market debt: A potential source of diversification
In addition to providing income, EM bonds can also help to diversify core fixed income portfolios, which tend to be composed primarily of traditional, interest rate sensitive sectors.
Source: FactSet, as of 7/31/2016
The chart above illustrates this diversification potential by comparing the rolling correlation of EM debt in the past two years to the Barclays U.S. Aggregate Bond Index (the Agg), a traditional core fixed income benchmark. Over the long run, EM debt has a fairly low correlation with the Agg, allowing it to add an element of diversification to a traditional fixed income portfolio.
Active management’s role in emerging market debt
EM debt is a broad category that includes local government bonds, dollar-denominated government bonds, local corporate bonds or dollar-denominated corporate bonds. Each type of EM debt comes with its own risk and return characteristics that necessitate different levels of analysis. Given this, investors considering an exposure to emerging market debt may want to do so using an active strategy.
Source FactSet, as of 6/30/2016
This chart captures the large divergence of returns we’ve seen in the past nine years across the EM debt universe. As shown above, the return profile of EM debt in any given year is quite diverse, reinforcing the idea that not all EM debt is the same. This creates a prime opportunity for active managers with an understanding of emerging market debt risk and return to help investors navigate the more complicated EM debt environment and select individual bonds to hold in a portfolio.
Investors seeking an actively managed approach to EM fixed income can consider the SPDR® DoubleLine® Emerging Markets Fixed Income ETF [EMTL], which invests in EM corporate and sovereign bonds.
In a world where yields remain stuck at extraordinarily low and even negative levels, EM debt and EMTL may be attractive choices for investors seeking income, diversification and total return opportunities. To learn more about EM debt and EMTL, access the EMTL Fund Details.
EM Debt
Emerging market debt represents bonds issued by countries or entities domiciled within countries that are considered to be less developed.
Emerging Markets
An emerging market economy is a nation's economy that is progressing toward becoming advanced, as shown by some liquidity in local debt and equity markets and the existence of some form of market exchange and regulatory body.
Interest Rate Risk
The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve, or in any other interest rate relationship.
JPMorgan GBI-EM Broad Diversified Index
The index is one of three main composite indices that make up the JPMorgan Government Bond Index – EM Diversified Index, which provides a measure of local currency denominated, fixed rate, government debt issued in emerging markets. The GBI-EM Broad Index is the all-encompassing index. It includes all eligible countries regardless of capital controls and/or regulatory and tax hurdles for foreign investors.
