Down But Not Out: Emerging Market Bonds

Lately, the headlines have been dominated by stories about how badly emerging markets (EMs) are doing.

Indeed, EM stock markets are down by as much as a third or more in dollar terms. The iShares MSCI Emerging Markets ETF (EEM), for instance, is trading at May 2009 prices. Compare that to the U.S. market, which stands at double that level.

All told, it may be time for some bottom-fishing. However, for income investors, stock markets might not be the best place to cast a line. Instead, emerging market bonds look like the better option.

Now, it’s true that EM bonds have one major disadvantage to EM stocks. That is, their tendency to come from countries in which you wouldn’t want to invest. Whereas EM stocks arise primarily from the growth economies of Asia, EM bonds have a tendency to come from countries such as Russia and Brazil.

In the iShares JPMorgan Emerging Markets Bond ETF (EMB), the largest country weighting is for the Philippines, but the rest of the top 10 are Russia, Turkey, Indonesia, Mexico, Brazil, South Africa, Hungary, Colombia, and Poland. Of those, I wouldn’t want Russia, Turkey, Brazil, or South Africa. Call me fussy, why don’t you!

Another problem is that truly solid emerging market bonds trade at foolishly small premiums to Treasuries.

The Philippines, for example, is an excellent credit risk because it runs balance of payments surpluses almost every year and is currently running budget surpluses, as well. Yet its bonds are rated only BBB, and 10-year Philippines bonds yield 3.26%. That’s a premium of just 1.06% over 10-year Treasuries. I really can’t get excited about that kind of yield.

Luckily, you can improve the risk-return equation in emerging market bonds if you buy bonds denominated in local currencies.

As often happens, “currency risk” is really “currency opportunity.” Because of the panic this summer, emerging markets currencies have been knocked down by 20%, 30%, or even 40% against the dollar – even though most emerging markets don’t currently have significant inflation. That makes local currency EM bonds a better deal than dollar bonds.