Wednesday, May 27, 2015

Emerging Market Bonds

Back in February, I shared details of one of our long term plans for my wife’s portfolio of moving funds from an expensive mutual fund to low cost diversified ETF portfolio. This was also one of our financial goals for the year, which we were happy to put behind us. The post Building an ETF Portfolio can be found here. The long term goals of the portfolio remain the same as discussed, which includes passivity (following the passive investing route), simplicity, diversification, expense check, and dollar cost average into the selected funds.

One thought that I’ve been debating for that portfolio is adding diversification in the fixed income portion. The fixed income exposure, which makes 40% of my wife’s portfolio comes from a single ETF called the BMO Aggregate Bond Index ETF (ZAG.TO). The ETF consists of high quality bonds (43% of the fund is made of AAA rated bonds) – consisting of federal, provincial and corporate debt.

Emerging Market Bonds

The high credit rating is great for safety. But on the flip side, we have to settle for relatively low yields as the risk is low. While the 3% yield of that fund is nothing to sneeze at, especially in the current low yield market environment, I have been reading up more about emerging market bonds – which are slightly riskier but investors get compensated with higher yield – which can be close to 5%.

Emerging Markets equities and fixed income components provide a great opportunity to diversify by accessing those markets. The following figure from Research Affiliates provides a nice overview of each asset class and where they lie in the Volatility vs. Expected Results chart. As you can see, the Emerging Market (EM) provides some good opportunities both in equities and fixed income markets.
It is interesting to note that the expected returns of the EM bonds in local-debt is much higher than non-local debt (which is usually the US$). Looking at all the ETFs available, the EM local-debt performance has been terrible for the last few years – and it makes sense, since investors have found better returns in equity markets in high quality companies.

My Take

If the chart above is to be believed, adding non-local (hard currency) debt has a similar volatility and expected returns close to high yield bonds. So, why not simply invest in high yield bonds then?

If we want a slightly different volatility/risk/return from adding an EM component, we are better off adding a local currency debt product. What makes it really interesting is that each country’s local currency debt makes things more complicated and coupled with the strength of the US$, which is expected to continue, I think those ETFs will continue to under perform. The reason to add now would be to hedge against some sudden downturn. Another major problem is the lack of availability of products in the Canadian market space (there are about three such products in the US market – and we have to take currency conversion issues into account). This article from Morningstar explores the options available and also raises some good points about the risks involved with investing in EM bonds.

Considering all the points above, and the fact that we are in the midst of a global bond market meltdown ($450B was wiped out in the last few weeks across the global bond markets) we will just be watching from the sidelines on this front. For now, the plan remains to educate myself and understand the marketplace.
What are your thoughts about the bond market, emerging markets equities and bonds? Share your thoughts below.

Full Disclosure: Long ZAG.TO. Out full list of holdings is available here.


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