Advisors may want to up their emerging market bond allocations

Yes, there is risk in emerging market bonds – but not as much as many advisors and investors believe. And especially not in the current global economic environment, says Eric Fine, head of emerging markets active debt at VanEck.

In Fine’s view, emerging market bonds will outperform developed market, or DM, issues as a result of lower debt levels, sound economic policies, and better risk-return profiles in a large number of emerging market bond markets. A recent report from Fine’s team at VanEck says high debt and deficits in developed markets have limited the traction of monetary policies.

Meanwhile, the report says emerging markets have maintained more advisable fiscal and monetary strategies, allowing for greater policy flexibility. Furthermore, the VanEck study showed that EM deficits, most notably in Asia, are consistently lower than those of developed markets and are forecast by the IMF to continue to be so.

As for geopolitical risk, which tends to be the prime reason that advisors avoid any type of EM investing, Fine says many of those the problems are actually tailwinds for EM bonds.

“They tend to be commodity supply stories and most of EM, certainly dollar-denominated bonds, many of them are commodities exporters,” said Fine. “So these things that advisors look at as risks to most of their portfolio, EM bonds are winners while paying you high yields.”

As for those high yields, one specific issue that Fine likes is a dollar-denominated bond issued by Mexican oil company Pemex, which yields 9.4 percent and matures in 2027. Another example in local currency is a Brazilian bond that yields 10.5 percent in a nation where inflation is in the 4 percent to 5 percent range.

“They were hiking way early,” said Fine. “And they've already started their easing cycle.”

As for how Federal Reserve policy changes will impact EM debt, Fine believes the fact that Fed policymakers might soon be initiating a rate-cut cycle will increase investor attention on bonds.

“Once you have your eyes on bonds, the first thing you're going to notice is wow, EM bonds did a lot better than I knew they did,” Fine said.

In terms of recent performance, the VanEck Emerging Markets Bond Fund (EMBUX), which Fine manages, returned 11 percent in 2023 after falling 7.2 percent in 2022. The EMBUX currently yields 7.4 percent.

By comparison, on the domestic front, the iShares Core US Aggregate Bond ETF (AGG) was up only 5.6 percent last year after falling 13 percent in 2022.

AN EMERGING ALLOCATION

A very low portion of advisors allocate client assets to EM debt funds, and those that do generally don’t stock up on them. US pension funds typically hold about 3 percent of assets in EM bonds, compared to 5 to 20 percent in developed market bonds from Asia and Europe.

In Fine’s opinion, EM bond allocations have nowhere to go but up, and he believes that’s exactly where they should be headed.

“If you look back on the last 20 years and do the efficient frontier exercise, and essentially say, ‘If I could have a time machine and go back 20 years,’ then you would have had 18% in emerging market bonds,” he said.

Eric Woodraska, client portfolio manager at Helios, an OCIO for advisors, has closely watched the strong performance in EM debt during the first quarter's “risk-on” environment. He cautions, though, that each EM bond fund tends to overweight a different country, so a strong due diligence process is important when investing in EM debt.

“You will often see countries in the top three of one fund not crack the top five in another,” he said. “Each country has a unique risk/return profile, so security and country selection are very important in the investment process.”

Woodraska says he tends to allocate to EM debt when there have been sustained periods of outperformance rather than trying to perfectly time the top or bottom of the market.

“We have seen that trend-following in the space can produce positive returns,” he said.

That said, Dan Pazar, executive vice president at Taiko, an OCIO for RIAs, says he's not racing to get exposure to EM debt now, but has historically viewed the asset class as a “tactical trade” during times of major market dislocations or as a US dollar hedge.

“If you invest in EM debt, be mindful of the manager’s resources and if they can truly get an informational advantage by having boots on the ground abroad if they are fundamentally investing in local economies,” Pazar said. “Generally speaking, EM debt would be a smaller allocation within models to the tune of 3 to 5 percent, but probably not much more. We have more of a rent-the-space mindset when it comes to EM debt.”

Tom Graff, chief investment officer at Facet, says he's not currently allocating assets to EM debt, and especially EM sovereign debt, where he believes the political risk is difficult to underwrite.

“Willingness to pay is often a central issue, and we find that difficult to ascertain,” he said.

In terms of EM corporate bonds, Graff said that he does have some exposure through general corporate bond ETFs, but that that exposure is limited and all dollar-denominated.