The Emergence of Emerging Market Bonds
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One of the advantages of working in a frontier market like Vietnam is that one can see first-hand the growth that is occurring here. It also gives you a sobering look at the amount of potential risk you face as well. While equity markets locally are often thinly traded and extremely volatile, bonds offer a completely different way to play the growth story of an up-and-coming country, without having to pick specific winners in a place where reliable financial information as rare as reliable electricity.
Emerging-market bond funds have been a favorite spot for savvy investors to park some of their funds since the financial crisis started in 2008 after the fall of Lehman Bros. Since 2008, more than $29 billion dollars have flowed into them total. The relatively large tidal wave began in earnest when the global economy emerged from recession in 2010, and more than $13 billion flowed into funds administered in the West. A recent article in The Wall Stree Journal tallied up that the average return on one of these funds has been 9.2% over the past five years.
The iShares JPMorgan USD Emerging Market Bond Fund ETF (NYSEMKT: EMB) is a $5.3 billion fund that is up 8.96% year to date and is paying a stout 4.5% dividend yield. In comparison the iShares Barclays 20+ Year U.S. Treasury Bond ETF (NYSEMKT: TLT) is up just 2.75% while paying a 2.8% yield. That outperformance, however, is only a recent phenomenon. The returns from TLT going back 5 years are far superior to that of EMB, outperforming it by more than 2:1, 40.2% vs. 18.2%.
U.S. Treasuries have benefitted from the chaos of the U.S. and European banking systems as capital has flowed there out of an almost existential fear. Many institutions have no other choice once they’ve reached their cash limit but to park their funds in sovereign debt of some form. But that trade has become so crowded that we are seeing capital leak away around the edges of it into other asset classes that provide 1) better yield and 2) a better long-term fiscal pictures.
So, in 2012, with yields on both U.S. and Japanese government bonds reaching zero-bound at the long end of the yield curve thanks to Operation Twist and the BoJ’s own version of it, retail investors have made the decision to seek yield elsewhere. The chart shows the relative performance of TLT and EMB. I’ve added in the iShares Barclays 3-7 Year Treasury Bond ETF (NYSEMKT: IEI) and the PowerShares Emerging Markets Sovereign Debt ETF (NYSEMKT: PCY) to provide some more color to the discussion.
EMB is focused on higher-quality, more advanced markets like the Philippines, Brazil, Russia, and Mexico and holds more than 20% in corporate paper, while PCY has significant holdings in far riskier places like Vietnam, Pakistan and Turkey in exclusively in sovereign debt.
It is plain to see that the Emerging Market ETFs are outperforming both short- and long-term U.S. Treasury bonds in terms of both price appreciation and overall yield. What is important to note, however, is that while U.S. Treasuries have rallied hard, in the second quarter there was not a commensurate sell-off in emerging-market debt, indicating that while the dollar was strong in international trade sending many of these countries' currencies down in the currency markets, investors were not selling their debt. In fact, they’ve been buying it -- and selling U.S. Treasures on balance.
As a matter of fact, since the markets abruptly turned on July 23,when the CurrencyShares Euro ETF (NYSEMKT: FXE) bottomed at $119.73 -- it has since rallied 4.9% to $125.60 on Sept. 6 -- this capital flow from the U.S. back to emerging markets has intensified. The market is showing no desire to uphold the long end of the U.S. treasury yield curve now that the extension to Operation Twist is over. It should scare investors deeply that money is preferentially flowing into Vietnamese government bonds than U.S. ones.
If the announcement by the E.C.B. on Sept. 6 of an unlimited sterilized bond buying operation is not challenged by the German Supreme Court next week, by ratifying the validity of the Exchange Stabilization Mechanism then we have seen the last of serious selling in the EURUSD pair. The Federal Reserve has already indicated that they stand ready to provide another round of quantitative easing, which they need to do. This will send the Euro back towards $1.40 and should send the U.S. dollar down versus most of the currencies who lost the most during the nearly 5 months that the fear trade was in effect.
At this point, emerging markets bonds are emerging as one of the safer asset classes for those who have need of a regular income stream, as countries like Indonesia, the Philippines and Malaysia have seen GDP growth that is rising against the tide of debt deflation in the West.
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