Emerging Market Bonds

Quick post about emerging market bond investments, that I wanted to make since my review of GMO mutual funds and specifically the outstanding long-term returns from GMO's GMCDX emerging market bond mutual fund:

As you can see that in the last 19 years or so that mutual fund has returned about 1800%, far exceeding even the very substantial returns from emerging market equities. And though GMCDX returns have been particularly impressive, as a category emerging market bonds easily beat almost every other major asset class with around 650% average return over the same time period. So, should investors be piling into GMCDX and other emerging market bonds today to capture similar returns going forward?

Sadly, no. Nothing even remotely close to their incredible past returns should be expected from emerging market bonds going forward. In fact they appear rather overpriced compared to alternatives. GMCDX is a bit hard to analyze since it's an actively managed mutual fund whose holdings are not updated daily for public benefit, but there are several emerging market bond ETFs which serve as a good proxy for the entire asset class and whose up-to-date holdings are in the open.

Emerging market bond investments come in two major flavors -- US Dollar-denominated debt and local currency debt. US Dollar-denominated debt is the safer of the two since it insulates the investor from currency risk. Most emerging market bond investments available to US investors are of the US Dollar-denominated kind, but there are at least two -- WisdomTree ELD and Market Vectors EMLC ETFs -- that invest in local currency debt. Looking at the actual valuations it appears that both US Dollar-denominated and local currency emerging market debt are destined for very pedestrian returns even in the best of circumstances. Let's look at the four largest ETFs in this space: iShares EMB, PowerShares PCY, WisdomTree ELD, and Market Vectors EMLC.

EMB invests in US Dollar-denominated emerging market debt. It has BB- average credit rating, 12-year average maturity, 4.0% YTM, and 0.6% expense ratio, resulting in expected return to investors of about 3.4% to maturity.

PCY also invests in US Dollar-denominated emerging market debt. It has BB average credit rating, 15-year average maturity, 4.5% YTM, and 0.5% expense ratio, resulting in expected return of about 4.0% to maturity.

ELD invests in local currency emerging market debt. It has BBB average credit rating, 7-year average maturity, 4.4% YTM, and 0.55% expense ratio, resulting in expected return of about 3.8% to maturity.

EMLC invests in local currency emerging market debt. It has BB average credit rating, 7-year average maturity, 5.2% YTM, and 0.47% expense ratio, resulting in expected return of about 4.7% to maturity.

As you can already see the best-case scenario for any of these funds is return of well under 5% to maturity -- in fact, under 4% in three of the four cases. And this is assuming no defaults, which is a very big assumption for securities that on average fail to reach (or barely reach) investment-grade level. There aren't enough countries in the world to form meaningful statistics about expected default rates, but for for US corporate debt of similar credit rating, average defaults have been on the order of 1% annually (although with very large variations). So that's another 0.5-1.0% that's prudent to subtract from annual expected returns of these securities.

So we are looking at likely returns of 3-4% annually over the next 7-15 years from emerging market bonds as opposed to well over 10% they have returned in the previous two decades! And these will not be smooth 3-4% by any means. Emerging market debt is not as volatile as emerging market equities, but you can still expect it to plunge if and when the next crisis comes around. It's roughly as volatile as US junk bonds (which makes sense, since they are similarly rated).

And speaking of US junk bonds -- while also clearly overpriced, you can get 7-year B-rated US junk bonds (via ETFs HYG or JNK, for example) with YTM of 6% and expected return after costs (and before defaults) of about 5.5% annually. Subtract another 2% or thereabouts for defaults and we're looking at the same 3-4% return over 7-year timeframe with no currency risk.

Bottom line, future returns from emerging market bonds will be nothing like what they have been in the past. They can be expected to return in 3-4% annual range in the next decade, with the usual significant volatility that comes with sub-investment-grade fixed income. There is absolutely no reason to invest in these securities today. Similar or better returns can be obtained from US corporate junk bonds -- despite the fact that those junk bonds are themselves are likely overpriced on spreads against US investment-grade corporates.