Tuesday, December 1, 2015

The Case for an Allocation to Dollar Based EM Debt

While the underperformance of high yield bonds since my post The Case Against High Yield has certainly made high yield bonds more attractive (yields went from sub 6% to north of 8%), I still prefer the risk/return profile of a stock/bond allocation (more here). For those that are looking for a higher yielding fixed income alternative with limited currency risk and the potential for U.S. interest rate diversification, dollar based emerging market fixed income may be an interesting alternative.

What is it?

The Barclays EM USD Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes USD denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. The index is broad-based in its coverage by sector and by country, and reflects the evolution of EM benchmarking from traditional sovereign bond indices to Aggregate-style benchmarks that are more representative of the EM investment choice set. 
At present the index is made up of ~75% sovereign debt and ~25% corporate debt, all denominated in the dollar, while the below table breaks down what it looks like in terms of country composition. Interesting to note that while only 2% of the portfolio is composed of Venezuelan debt, that 2% contributes more than 10% of the overall yield of the index (in other words, the higher yield is certainly not risk-free), but the index does provide a pretty wide breadth of exposure.

The EM Debt Relative Valuation Story

The case for EM USD Aggregate exposure is simply a relative valuation story. Despite periods of heightened turmoil within emerging markets over the last 20+ years, the yield to worst of the portfolio has generally been a pretty good predictor of future returns (note six years is used for the forward return projection given the duration of the index has fluctuated between around 5-7 years going back to the 1993 inception).

At the current yield of almost 6%, forward absolute returns are likely to be favorable.

The higher yield becomes more intriguing when viewed relative to the yield of the U.S. Aggregate Bond index. The below chart is similar to the one above, but is shown with yield to worst and forward returns relative to that of the U.S. Aggregate Bond index. In this case the relative yield advantage has been a pretty consistent precursor to future outperformance. A notable exception is the underperformance in the mid 1990's which coincided with six year returns impacted by the 1998 emerging markets crisis (though the yield advantage was sub 2% then vs almost 4% today).

While emerging market bonds are certainly not risk-free, the US dollar denomination protects an investor from a direct impact should the dollar continue to strengthen (though countries trying to pay back dollar denominated debt with a weakened currency are certainly indirectly impacted), while relative yields that are near all-time wide levels vs the US Aggregate index seem attractive given the "emergence" of emerging market countries on the global economy over the more than 20 years since the index incepted. Add in the potential diversification benefits moving some fixed income away from US monetary policy may provide and you get what is in my view a strong case for a strategic allocation to emerging market fixed income.