How Emerging Markets Bonds Enhance Portfolio Construction
Historical Performance of Emerging Markets Bonds
This blog, the final of our five-part series, concludes with a brief overview of the performance characteristics and potential opportunities available when investing in the asset class from a portfolio construction perspective.
The historical performance of various sectors of emerging markets bonds is shown below compared to certain developed markets fixed income asset classes. The chart also shows emerging markets equities which have actually underperformed emerging markets bonds over the period and with much higher volatility.
Comparable 10-Year Returns: Emerging Markets and U.S. High Yield Corporate Bonds
Over the 10-year time period analyzed, U.S. dollar-denominated sovereign bonds outperformed most other fixed income sectors on both an absolute and risk-adjusted basis. Local currency sovereign emerging markets bonds were more negatively impacted by events of the past few years, including slower global growth, a strong U.S. dollar, and weak commodity prices. Within emerging markets corporate bonds, those rated high yield provided returns comparable to U.S. high yield bonds over the period.
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From a diversification perspective, emerging markets bonds generally exhibit a moderate correlation to other core fixed income asset classes. As one might expect, U.S. dollar-denominated emerging markets sovereign bonds exhibit a higher correlation to U.S. dollar asset classes than local currency emerging market bonds.
Limiting duration while focusing on quality
Emerging market (EMLC) (PCY) debt can be a great source of income potential in a diversified portfolio, provided you can manage it during a period of extreme volatility. As we saw in the previous part of this series, investors generally shift to investment-grade bonds during heightened volatility, and local bonds perform well when the local currency is strengthening.
Duration measures a bond’s sensitivity to changes in yield. Due to their inverse relationship with interest rates, bonds are highly sensitive to yield changes. The shorter the duration, the less damage there will be from a rise in yields.
The Sharpe ratio measures a fund’s risk-adjusted return. A higher Sharpe ratio is better. As you can see in the above graph, US dollar-denominated sovereign bonds outperformed most other fixed income sectors on both an absolute and risk-adjusted basis. They’ve returned ~6.9% in the last ten years with a Sharpe ratio of 0.71.
To limit the risk involved in investing in emerging market bonds (EMB) (EMAG) (IGEM), you can shorten the duration and focus on quality. Over time, high-quality, short-duration bonds have dampened portfolio volatility and held up better in down markets.