Where to Find Yield in the Global Bond Markets
U.S. Investors Should Look Abroad for Higher Fixed Income Yields
There’s little doubt that the United States and European bond markets may be headed for trouble. According to Goldman Sachs analysts, bondholders could lose as much as $1 trillion if Treasury yields rise unexpectedly by one percentage point. Many investors have responded by looking to riskier bonds to boost their higher yields, such as high-yield or junk bonds, but international investors have several other options worth considering.
In this article, we will take a look at global fixed income investments that may offer a better alternative than higher risk U.S. and European securities.
The Case for Emerging Market Bonds
Emerging market corporate bonds offer opportunities due to information gaps, liquidity challenges, and less research coverage than other sectors, according to T. Rowe Price analysts. The bonds offer yields that are 100 basis points higher than similarly rated U.S. corporate bonds, while spreads are even greater relative to European or Japanese bonds given the extremely low or negative yields in those regions.
Emerging market sovereign bonds have also become increasingly higher quality over the past decade. According to Bloomberg data, more than 60% of emerging market bonds are investment grade today compared to just 30-40% 10 years ago. It’s worth noting that some emerging markets remain risky — such as Brazil — but most have been steadily improving their economies over the past decade thanks to favorable demographic trends.
The International Monetary Fund also notes that many emerging market economies have experienced solid economic growth, accumulated reserves, and built up strong balance sheets to support their debt loads. In its July 2016 World Economic Outlook, the organization raised its growth forecast for these markets, saying that improvements have been seen in previously troubled emerging markets like Russia and Brazil.
Building Exposure to Emerging Market Bonds
International investors have many different options when it comes to emerging market bonds, including both corporate or sovereign bonds across hundreds of countries.
Emerging market sovereign bonds are backed by foreign governments rather than private corporations, which makes them a safer option due to the lower risk of default. Investors looking to maximize diversification can build exposure to foreign currency movements with local currency funds. In contrast, those that want to hedge out any currency risks can invest in currency-hedged funds that buy debt in U.S. dollars.
Some popular emerging market sovereign bond funds include:
- iShares JP Morgan USD Emerging Markets Bond ETF (EMB)
- iShares Emerging Markets Local Currency Bond ETF (LEMB)
Emerging market corporate bonds are issued by private or public corporations, which means they are riskier with a higher yield. Most investors should consider traditional corporate bond funds that offer exposure to a broad range of corporations. Alternative, those looking to take on more risk may want to consider high yield bond funds that invest in corporate bonds trading below investment grade — meaning they have a higher probability of default.
Some popular emerging market corporate bond funds include:
- iShares Emerging Markets Corporate Bond ETF (CEMB)
- iShares Emerging Markets High Yield Bond ETF (EMHY)
Risks to Consider
Emerging market bonds have a number of unique risk factors that investors should carefully consider before making a decision.
Currency risk is the risk of a local currency declining in value compared to the U.S. dollar, which creates losses upon conversion back into U.S. dollars. In the recent low-interest rate environment, currency-hedged ETFs have outperformed local currency ETFs, but many experts argue that local currency ETFs offer the best diversification. Emerging market ETFs also tend to be a lot riskier than developed ETFs due to their lower overall credit quality.
International investors can mitigate these risks by ensuring that their portfolio is diversified across various emerging market countries. This diversification ensures that no individual country’s currency or government derails an entire portfolio’s performance. For instance, many of the aforementioned bond funds have seen robust performance over the past year despite the economic difficulties seen in countries like Brazil.
The Bottom Line
United States and European bond markets have become increasingly risky due to their extremely low interest rates. With the Federal Reserve looking to hike rates, these bonds could be at risk of seeing significant price in the near future. Emerging market sovereign and corporate bonds may offer far better yields with less risk. In general, these bonds have witnessed improving credit quality driven by robust growth.