Emerging market bonds: The pros and cons of investing

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This changed in May/June 2013 as investors became concerned about credit risk and yield spreads widened in response. Since that time we have seen a steady tightening of investment grade  (AGG) and high yield credit (HYG) spreads across the board as investors have moved back into those sectors.

EM spreads have tightened some as well, but not nearly as much. As a result, the yields on EM debt appear to be unusually wide given the credit quality of the issuers. EM credit spreads are trading near those for the high yield market (HYG), even though almost 70% of the EM issuers in a broad EM vehicle, like the iShares Emerging Markets USD Bond ETF (EMB), are investment grade.

 Source: BlackRock as of 5/9/2014

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The above chart highlights the divergence in spreads that has occurred since 2012. The question for investors today is, will EM rally versus corporate bonds? It’s hard to say. Keep in mind that part of what is keeping EM wide is that the universe, and in particular EMB, include exposure to the debt of countries that have dominated headlines lately. This includes Russia (RSX), which makes up 5.61% of EMB, Ukraine which makes up 2.85%, and Brazil (EWZ) which makes up 6% (Source: BlackRock as of 5/1/2014).

It is certainly possible that EM debt can remain at elevated spread levels if we continue to see political and economic challenges in the issuing countries. At the same time we are seeing some investors move back into the sector as evidenced by the $584 million of flows into EMB this year through May 1st (Source: Bloomberg). Bottom line, for investors looking to add yield to a portfolio, EM debt (EMB) may be an alternative they should take a closer look at. Just remember that, as always, yield isn’t free.

Market Realist – The emerging market bond index has an average maturity of 12.1 years. This long period increases exposure to credit and geopolitical risk.

The emerging market index is currently giving yields of 5.1%, which is 2.6% above ten-year U.S. Treasuries (IEF). Historically, the spreads have been placed at 4.4%, which means the current spread is much below average.

A large portion of the emerging bond markets comprises South American debt, which may prove to be risky, given the current setup. S&P recently cut Argentina’s ratings to selective default due to non-payment.

Emerging market bonds are valued better in the current context and present higher yields along with better growth prospects. Risk comes with all the positives, though. You need to adopt a cautious approach while investing in this asset class.

Read our series An investor’s key guide to international bond funds to learn more about the variants in emerging market bonds.

Holdings are subject to change.

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Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets, in concentrations of single countries or smaller capital markets.

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