Emerging market bonds for yield and diversification
29 May 2014
Despite pockets of recent instability in countries like Ukraine and Turkey, emerging markets are today generally seen as less risky than in earlier years. In addition, while emerging market growth rates have not recovered to pre-crisis peaks, they still generally outpace developed markets1.
Emerging market bonds therefore present an attractive opportunity for investors seeking portfolio diversification. Today, emerging markets – with manageable government debt levels, lower than in many developed countries – offer a middle-road investment path, in an environment known for its extremes, where the risk-reward ratio is favourable.
Central banks in a number of developing countries have shown their willingness to counter inflation – which is partly due to the large decrease in exchange rates over the past few months – with contractionary policies. Expected returns on emerging market bonds will be significantly higher than those of government bonds and high-yield bonds in developed markets.
Hard currency emerging market bonds provide a second level of protection, allowing investors to avoid the risks associated with local currencies, such as devaluations necessary to restore current account balances.
Another factor contributing to a shift towards emerging markets is the so-called “demographic dividend”: with young populations2 and high growth rates, emerging markets are already home to more than 80% of the global population . Between now and 2025, another billion people will be born – almost all of them in emerging markets3 . Abundant natural resources, including about 90% of proven global oil reserves4, are an additional driver of long-term expansion, including ever-increasing South-South trade.
Not all emerging markets are created equal, however. Latin America, with its proximity to the US and high yields, will benefit early from foreign interest in sovereign debt – interest that will not yet be coming from Europe.
Insignificant current account deficits (versus foreign currency reserves) and the ample liquidity available in the region make the risk-reward ratio more attractive than in cross-over and high-yield debt markets.
Emerging market borrowers – including both sovereign and corporate issuers – raised just over $100 billion of debt in the first quarter of this year, slightly below the total during the same period in 20135. There is every reason to believe, however, that as investors continue the search for yield, they will increasingly turn to emerging market bonds.
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