Emerging Market Bonds

Back in February, I shared details of one of our long term plans for my wife’s portfolio of moving funds from an expensive mutual fund to low cost diversified ETF portfolio. This was also one of our financial goals for the year, which we were happy to put behind us. The post Building an ETF Portfolio can be found here. The long term goals of the portfolio remain the same as discussed, which includes passivity (following the passive investing route), simplicity, diversification, expense check, and dollar cost average into the selected funds. One thought that I’ve been debating for that portfolio is adding diversification in the fixed income portion. The fixed income exposure, which makes 40% of my wife’s portfolio comes from a single ETF called the BMO Aggregate Bond Index ETF (ZAG.TO). The ETF consists of high quality bonds (43% of the fund is made of AAA rated bonds) – consisting of federal, provincial and corporate debt.

Emerging Market Bonds

The high credit rating is great for safety. But on the flip side, we have to settle for relatively low yields as the risk is low. While the 3% yield of that fund is nothing to sneeze at, especially in the current low yield market environment, I have been reading up more about emerging market bonds – which are slightly riskier but investors get compensated with higher yield – which can be close to 5%.

Emerging Markets equities and fixed income components provide a great opportunity to diversify by accessing those markets. The following figure from Research Affiliates provides a nice overview of each asset class and where they lie in the Volatility vs. Expected Results chart. As you can see, the Emerging Market (EM) provides some good opportunities both in equities and fixed income markets.

Asset Classes

It is interesting to note that the expected returns of the EM bonds in local-debt is much higher than non-local debt (which is usually the US$). Looking at all the ETFs available, the EM local-debt performance has been terrible for the last few years – and it makes sense, since investors have found better returns in equity markets in high quality companies.

My Take

If the chart above is to be believed, adding non-local (hard currency) debt has a similar volatility and expected returns close to high yield bonds. So, why not simply invest in high yield bonds then?

If we want a slightly different volatility/risk/return from adding an EM component, we are better off adding a local currency debt product. What makes it really interesting is that each country’s local currency debt makes things more complicated and coupled with the strength of the US$, which is expected to continue, I think those ETFs will continue to under perform. The reason to add now would be to hedge against some sudden downturn. Another major problem is the lack of availability of products in the Canadian market space (there are about three such products in the US market – and we have to take currency conversion issues into account). This article from Morningstar explores the options available and also raises some good points about the risks involved with investing in EM bonds.

Considering all the points above, and the fact that we are in the midst of a global bond market meltdown ($450B was wiped out in the last few weeks across the global bond markets) we will just be watching from the sidelines on this front. For now, the plan remains to educate myself and understand the marketplace.

What are your thoughts about the bond market, emerging markets equities and bonds? Share your thoughts below.

Full Disclusire: Long ZAG.TO. Out full list of holdings is available here.

5 thoughts on “Emerging Market Bonds

  1. Hey R2R. Thank you for the article. I haven’t read up on emerging market bonds and can’t really add to the discussion. However, I still believe Bonds such as ZAG or VAB is important for our portfolios. They’re definitely HIGH quality Bonds.
    Personally, I’d allocate maybe 10 to 20 percent for myself but for my wife, I like 40 to 50 % for hers. In a couple of more years, I’d really start to invest more on Bonds and would average out 25%.
    I don’t need to search elsewhere in search for yield and happy with 3% yield from VAB because the Equities / REITs / Preferreds make up with it’s own yields going forward. Averaging the whole portfolio, the sweet and safe zone is about 3 – 5 %plus capital appreciation so that’s good enough for me. Also, Fluctuations in price doesn’t bother me because it’s the Income I’m searching for and most importantly, the safety of it.
    Tough call, as what works for me might not work for you as we’re all different.
    You take care and keep it up. Cheers my friend.

    • Some good points, DH. I am targeting something similar. I have a very small portion of my portfolio in bonds – and that just as part of an equity-income focused ETF (FIE.A), but other than that, I dont hold any bonds. My wife’s portfolio has 40% allocation – which I think makes up for both of us 🙂

      Like you said, 3% isnt that bad and for what the bond sector brings to the table, thats plenty. I dont really expect much of a capital appreciation in the bond ETFs unlike my equities holdings – so, it’ll just be purely for some stability and income.

      Thanks for sharing your thoughts. Appreciate the input.

  2. Another interesting topic R2R. I myself do not feel comfortable investing in any emerging market bonds. I have an International Stock index in my portfolio and of course some international stocks among my dividend stocks. I think sometime in the future I’d invest in some local municipal bonds, but I need to learn more about them. Thanks for sharing.

    – HMB

    • Emerging market bonds are a risky investment – but there is reward in that risk too…it all comes down to the personal preferences. Bonds play a different role in the portfolio that stocks cannot capture – I am waiting to see how the bond bust is going to play out before starting to add some bonds to my portfolio.

      Best wishes

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