Emerging-market bonds

  • Written by 
  • 16/09/2013
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Residents of the United States, please read this important information before proceeding

Please read this important information before proceeding.

Yields on government bonds have tumbled and are unlikely to offer much of a return to anybody who holds them to maturity. UK 10-year gilts currently offer just over 2.7 per cent, with inflation at 2.8 per cent as of August. Longer-dated bonds such as 30-year gilts have higher yields, but even these are low by historical standards and investors are taking risks by buying these; if inflation and interest rates pick up in future, the market value of these bonds could fall sharply.

So is there an alternative? Some investors are looking at emerging-market government bonds, arguing that some economies in the developing world look sounder in many ways than their developed-world counterparts. This may sound like madness to anybody who remembers the emerging-market debt crisis of the 1980s and 1990s, but there is some logic to it.

While governments in the developed world have generally seen their finances deteriorate in recent years, many in emerging markets have seen theirs significantly improve, as reflected in their debt-to-GDP ratios (see chart). Obviously, this does not apply to all emerging market countries, and investors should be cautious about whether the improvements are permanent. But, in many cases, the approach of emerging-market governments to fiscal and monetary policy has improved enormously, making a return to the bad old days seem less likely.

General government gross debt (% of GDP) graph

Source: International Monetary Fund

On the downside, investors are aware of this and have bought heavily into emerging-market bonds – and, as a result, the yields on these bonds have come down significantly. The yield on a 10-year Indonesian government bond, for example, has fallen from an average of 10 per cent over the past decade to around five per cent today. As a result, “hard currency” government bonds – those denominated in foreign currencies such as the US dollar or, less commonly, in sterling, euros or yen – may no longer be as attractive as they were a few years ago.

By contrast, “local currency” government bonds can still offer better yields to those willing to accept additional risks. These are denominated in the issuing country’s own currency, which means that investors are exposed to the risk of that currency falling in value but could get an additional boost from the change in the exchange rate if emerging-market currencies rise against developed ones over time.

Emerging-market corporate bonds – which are still usually denominated in hard currency, rather than local currency – are also a fast-developing market. Yields on these are usually higher than those of developed-market companies with similar credit ratings.

Investing ideas

Three emerging-market bond funds you may wish to consider are: the Threadneedle Emerging Market Bond Fund which invests mostly in hard currency bonds and currently yields five per cent; the Baillie Gifford Emerging Markets Bond Fund, which currently yields 4.6 per cent; and the Investec Emerging Markets Local Currency Debt Fund, which invests mainly in local currency bonds and currently yields six per cent. All three of these funds have four-crown ratings from Financial Express.

Despite the appeals of higher yields in these emerging market bonds, it is important to realise that there is a substantial risk of loss to investors, by the default of the issuers, whether governments or otherwise.