U.S. government and corporate bonds have been stingy for a decade, and now there’s the added danger that rising interest rates, while making bonds a tad more generous, could drive down prices. So, what about looking farther afield for bonds that pay more — to emerging markets like South Korea, Brazil Mexico or Thailand, for instance?
“In a low interest rate environment, higher yields found in emerging-market bonds are attractive,” says Ryan L. Davis, assistant finance professor at the University of Alabama at Birmingham.
Emerging markets, while always somewhat risky, have become a better bet in recent years, according to an analysis by FxPro Financial Services, an online brokerage.
“Developing countries are showing signs of growth acceleration once more, which positively affects bond prices,” and drives down yields, the firm says. “Fears regarding world economy prospects seem to trigger interest in emerging markets, which maintained a faster growth pace last year than the U.S. market.”
[See: 7 of the Best Stocks to Buy for 2018.]
Emerging-market bond funds have returned 6.41 percent over the past 12 months, compared to a loss of about 0.57 percent on long-term U.S. government bonds, according to Morningstar.
But although many experts say non-U.S. bonds have a role in U.S. investors’ portfolios, many also note there is no free lunch.
“Investors should be aware of the risk-return trade-off when considering emerging-market bonds,” Davis says. “While emerging-market bonds are known for their relatively high yields and returns, these debt instruments are riskier than U.S. government securities and corporate bonds.”
Because they are volatile, emerging-market bonds are not a suitable replacement for U.S. bonds, says Kevin Maloney, visiting professor of finance at Bryant University in Smithfield, Rhode Island. Instead, they belong in the riskier end of the portfolio alongside stocks.
“Investors should understand that the returns on emerging-market bonds will have higher correlations to equities than U.S. Treasury or municipal bonds, particularly in bear markets,” Maloney says. “If a primary goal of your fixed income allocation within your portfolio is to diversify your equity risk, emerging markets bonds are not an ideal asset to use.”
All bonds are loans from the bond buyer to the issuer. Issuers typically pay higher yields to attract investors who would otherwise be scared off by risks. And emerging-market bonds can entail a slew of risks on top of the ones investors face with U.S. bonds.
“The currencies of many emerging-market countries are very volatile, and there is often a significant risk that the value of these bonds will decrease in U.S. dollar terms” when bond proceeds are converted to dollars, says Thomas Rimer, faculty member in the finance department at Michigan State University.
“In addition, many of these countries have unstable economies, as well as troubled political systems, which puts timely interest payments and repayment of principle of government bonds at greater risk” than with U.S. bonds, he says.
[See: 7 of the Best Emerging Markets Stocks to Buy.]
The ideal emerging-market bond investor, Davis says, is one “looking to add some spice to their bond portfolio” or hoping “to diversify their bond portfolio through international exposure.” Foreign bonds are typically governed by different forces than those driving U.S. bonds, so they may go up when U.S. bonds go down, evening the portfolio’s performance over time.
Investors who are risk-averse and cannot stomach wild ups and downs should stay away from emerging-market bonds, Davis says.
Maloney notes that today’s conditions add some worries.
“The prolonged period of low interest rates engineered by easy monetary policy conditions in the U.S., Europe, and Japan has led investors to move out the risk curve in search of yield,” he says. “We have seen flows into fixed income assets with lower credit ratings, and from developed bond markets into emerging markets. This has pushed down yield spreads on riskier fixed income assets, including high yield bonds and emerging-markets bonds. This translates into lower expected returns going forward.”
Davis cautions that emerging-market bonds can be hard to research.
“Because the information environment surrounding some emerging market bonds is opaque, investors should be cautious,” he says. “When considering emerging-market bond funds, for example, investors should do their homework and see what the fund actually holds, its strategy, and how it fits in with their personal preferences and portfolio objectives. Investors should also make sure that their current portfolio holdings do not already provide exposure to emerging markets.”
Investors can buy individual emerging-market bonds through full-service brokers, but many choose mutual funds or exchange-traded funds as an easy way to diversify and leave the bond picking to pros.
Rimer says ordinary investors should not put more than 5 percent of their holdings into emerging-market bonds, and Maloney says the need for careful shopping makes active management a better choice than indexing.
[See: 7 ETFs to Buy As Interest Rates Rise.]
“Investing in emerging markets debt does lend itself to an active investment approach by seasoned professional investors,” he says. “Political risk analysis, detailed analysis of government financing and liquidity conditions, and local knowledge are important when investing in emerging markets, and picking individual EM bonds is not something that individual investors should attempt to do.”
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Emerging Markets Bonds Draw Investors originally appeared on usnews.com
