With low interest rates in the U.S. and outright negative rates in some overseas markets, the bond market probably isn’t the first thing to come to mind when investors are looking for yield.
But experts are pointing to some niches of the international bond arena that are yielding well above what can be had domestically, albeit with more risk.
Both high-quality and lower-quality bonds have been performing well in terms of price. High-quality developed market bonds have rallied with demand from risk-averse investors, such as those worried about Britain voting to leave the European Union.
[See: 10 Great Ways to Buy Emerging Markets.]
But of course as bond prices rise, their yields decline. So, needing to make money, investors have also been turning to lower-quality emerging market bonds. That also drives their price up, but these bonds simply yield more because they are riskier.
It can be tempting to stay within the U.S. in terms of bonds, says Richard Lawrence, senior vice president of portfolio management at Brandywine Global Investment Management, which is a subadvisor for the Legg Mason BW Global Opportunities Bond Fund (ticker: GOBIX). But that would be eschewing higher yields in emerging markets and some developed world bonds.
“You have to look beyond the headlines,” he says.
Emerging markets can be a good place to look for yield, but that’s because they are associated with certain risks, says Eric Stein, co-director of global income at Eaton Vance Management, which has the Global Macro Absolute Return Fund (EIGMX), the Emerging Markets Local Income Fund (EEIAX) and the Emerging Markets Debt Opportunities Fund (EIDOX). The three main risks for foreign bonds are currency, interest rates and default, he says.
International bonds also move in step with the Federal Reserve and U.S. Treasurys. If the Fed raises rates, that would cause bond yields elsewhere to rise, meaning their value would fall in the short term. This would only create a headwind for international bonds if the Fed raises rates more than expected and Treasurys sell off, Stein says.
If U.S. rates rise more quickly than expected, this could strengthen the U.S. dollar and cause some emerging market currencies to weaken.
Demand from China is also a risk as many emerging market countries are commodities producers and China is a large consumer, he says. A sell off in the Chinese currency can also send shockwaves through global risk markets, he says.
[See: 7 Global Goats That Could Bring Market Mayhem.]
Oil prices are also a risk, since many emerging market countries are oil exporters, he says.
With the top five global bond issuers — the U.S., France, Germany, the United Kingdom and Japan — all yielding low or negative rates, emerging market countries are “last bastions of yield,” says Meb Faber, a co-founder and chief investment officer of Cambria Investment Management.
Rising interest rates in the U.S. would lead to higher rates elsewhere. So in the short term, that would cause international bond prices to decline and their yield to go up, Faber says.
Whether international bonds will face a strong headwind as the Fed raises rates depends on how the market reacts to the pace of the hikes, Lawrence says.
A strong dollar acts as a headwind for investors in international bonds unless they hedge that currency exposure, he says, but this year, declines in the U.S. dollar have made it more sensible to buy securities denominated in other currencies.
Stein thinks the Fed will raise rates a little more than expected over the next two years, providing a slight headwind to some emerging market currencies.
For those looking for yield, Lawrence points to Brazil, where the 10-year bond is yielding around 12 percent. He also likes Mexico because of its correlation with the slowly improving U.S. economy and its Treasury market but much higher yield. South Africa is also attractive, with its 10-year bonds yielding about 9 percent and a slowly improving fiscal picture.
Both Lawrence and Stein point to Indonesia because of its reform agenda.
[Read: Emerging Markets Aren’t Submerging Any More.]
They also cite New Zealand as a niche of the developed world economies where investors can get higher yields without taking a lot of credit risk. However, Stein is bearish on the New Zealand dollar.
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What Are the Best International Bond Markets? originally appeared on usnews.com
