Enhance your fixed income with emerging market debt

Three reasons to look beyond traditional sources of income
Market Insights: October 5, 2017

Summary

  1. Canadian investment grade fixed income may no longer offer investors the income they need to meet their financial goals.
  2. Investors should consider expanding their opportunity set with emerging market debt, which offers potential for higher yields, an enhanced risk/return profile and protection against rising interest rates.
  3. The idiosyncratic nature of emerging market risk factors makes active management especially critical.

1. The income dilemma

A typical Canadian investor has 82%1 of their fixed-income exposure at home, with 78%2 of this exposure in government bonds and money market funds. For 30 years this approach worked, as Canadian investment grade bonds provided attractive yields, plus the added benefit of price appreciation from falling interest rates. But it appears this generational opportunity has come to an end, leaving many Canadian investors with an income dilemma.

Current low yields and the potential for meaningfully higher interest rates mean Canadian investment grade bonds are unlikely to provide the total return profile investors have become accustomed to.

Investors may have a better chance of finding the income they need and mitigating the risk of rising interest rates if they expand their opportunity set to include emerging market debt.

Table 1: Canadian investment grade bond performance – 1994 vs. 2017

Source: FTSE TMX Global Debt Capital Markets as at August 31, 2017. Based on FTSE TMX Canada Universe Bond Index.

The average coupon has declined, resulting in higher duration. This higher interest rate sensitivity, combined with lower income return, has reduced the total return potential of investment grade bonds.

2. Emerging market debt

A growing asset class that covers more than 70 countries and accounts for approximately US$16 trillion, emerging market debt offers a wide range of economic and interest rate environments. This translates into potential for (a) higher yields, (b) an enhanced risk/return profile and (c) protection against rising interest rates.

a. Higher yields

Emerging market debt has a higher yield profile than developed market investment grade bonds, which currently offer little to no yield. As Figure 1 shows, this is true of all three major emerging market asset classes:

  • Sovereign hard currency debt
  • Sovereign local currency debt
  • Corporate debt

Figure 1: Yield profile for emerging market debt
Source: Bloomberg, PineBridge Investments as at August 31, 2017.

b. Enhanced risk/return profile

Complementing the enhanced yields of emerging market debt is an attractive risk/return profile over five- and 10-year periods (Table 2).

Table 2: Risk/return profile of emerging market debt

Source: Morningstar as at August 31, 2017. Emerging market bonds are represented by a blend of static allocations to the following indexes: 1/3 JPM EMBI Global Diversified TR USD (sovereign hard currency debt), 1/3 JPM GBI-EM Global Composite TR LCL (sovereign local currency debt), 1/3 JPM CEMBI Diversified TR USD (corporate bonds).


Importantly, these periods include three significant “flight to quality” events, which would normally favour Canadian domestic investment grade bonds: the 2008 financial crisis, the 2013 taper tantrum, and the oil-price decline of 2015.

Emerging market debt is particularly beneficial when it complements a core portfolio of Canadian investment grade bonds. Over five years, a 15-30% allocation to emerging market debt offered an approximately 0.4 – 0.8% increase in annualized return while lowering overall volatility (Figure 2).

Figure 2: Adding emerging market debt to Canadian core fixed income
– 5 year

Source: Morningstar as at August 31, 2017. Emerging market debt is represented by a blend of static allocations to the following indexes: 1/3 JPM EMBI Global Diversified TR USD (sovereign hard currency debt), 1/3 JPM GBI-EM Global Composite TR LCL (sovereign local currency debt), 1/3 JPM CEMBI Diversified. Canadian core fixed income represented by FTSE TMX Canada Universe Bond Index.


Over 10 years, a 15% allocation to emerging market bonds adds nearly 0.5% in annual return with almost no change in volatility (Figure 3).

Figure 3: Adding emerging market debt to Canadian core fixed income
– 10 year

Source: Morningstar as at August 31, 2017. Emerging market debt is represented by a blend of static allocations to the following indexes: 1/3 JPM EMBI Global Diversified TR USD (sovereign hard currency debt), 1/3 JPM GBI-EM Global Composite TR LCL (sovereign local currency debt), 1/3 JPM CEMBI Diversified TR USD (corporate bonds). Canadian core fixed income represented by FTSE TMX Canada Universe Bond Index.

 

c. Protection against rising rates

Another benefit of emerging market debt is that it is not wedded to any single interest rate cycle. Instead, investors can capitalize on opportunities in countries where central banks – responding to country-specific economic conditions – are currently maintaining or lowering interest rates. The policy rate diversity of emerging markets can help investors overcome the current low-yield environment at home and take advantage of the falling interest rates that benefited them for so long.

Figure 4: Emerging market policy interest rates

Source: Bloomberg as at August 31, 2017.


Importantly, during periods of U.S. Federal Reserve interest rate increases, emerging market debt has outperformed other fixed-income asset classes (Table 3).

Table 3: Fixed-income asset class performance amid rising interest rates

Source: PineBridge Investments as at August 31, 2017. Returns are annualized.

3. An active, on-the-ground approach

Emerging market debt offers the potential for higher yields and better risk-adjusted returns, as well as protection from rising interest rates. But with the evolution of these markets over the last 30 years, their risk factors have largely shifted from systemic – impacting the entire asset class – to idiosyncratic (i.e., country or sector specific).

As a result of this shift, it is more critical than ever to gain exposure to emerging markets through an active, risk-managed approach that:

  • Opportunistically targets the optimal portfolio composition for the current environment
  • Employs a dynamic security selection process that combines top-down analysis of the global macroeconomic environment with intensive bottom-up credit research
  • Is guided by managers with extensive experience in managing emerging market assets and an on-the-ground presence to help identify idiosyncratic opportunities and risks

For an actively managed solution that provides diversified access to emerging market debt, retail investors can look to the IA Clarington Emerging Markets Bond Fund.

Dealer use only.1 IMF, Bank for International Settlements December 31, 2016. 2 OSC April 2015.

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