Where to turn in a yield starved world?
Before the GFC, Australian investors could invest in term deposits or government bonds and receive a stable, risk-free income that they could rely on to support them in retirement. But as interest rates have dropped over the last decade, a new era has begun in which the outlook points to low rates for longer.
We live in a new world.
Before the turn of the century, developed markets had positive real interest rates while emerging markets economies had little to no reserves, so the yield spreads on EM bonds were wide relative to US Treasuries.
Before the GFC, Australian investors could invest in term deposits or government bonds and receive a stable, risk-free income that they could rely on to support them in retirement. But as interest rates have dropped over the last decade, a new era has begun in which the outlook points to low rates for longer.
Last year, the world reached a peak of more than $17 trillion of debt with below-zero yields1. Meanwhile, Denmark and Switzerland made the record books for having the world record in negative interest rates at -0.75%2. Sweden and the Eurozone currently both have 0% interest rates3.
Investors are seeking alternatives to traditional income assets to both diversify and expand income sources.
The “new world” of emerging markets bonds
Emerging markets bonds are, as the name suggests, bonds issued by governments and companies in emerging markets. Despite emerging markets representing over 50% of global GDP, the level of EM bond issuance and investment is nowhere near what would be implied by their contribution to global growth.
Many emerging markets boast strong economic performance based on good economic policy decision making in the last 15 years, which has made them stronger than many of their developed market counterparts. For example, because they had worked hard to improve their reserves and their balance of payments, many EM countries came through the GFC in better shape than their developed market counterparts.
There is a new world order and emerging markets bonds are at the forefront of this change.
The past 15 years have demonstrated that EM bonds can reward investors without extreme risks previously associated with emerging market debt, as emerging markets data has become increasingly transparent and reliable and they built up their reserves.
EM bonds have produced positive returns in 14 of the last 15 years. 
And EM bonds have been offering attractive yields relative to developed market bonds.
Source: Bloomberg. Data as at 31 December 2019. Data is in Australian dollars. You cannot invest in an index. Past performance is not a reliable indicator of future performance of the indices or EBND. Indices used: Australian Bonds - Bloomberg AusBond Composite 0+ Yr Index; US Bonds - Bloomberg Barclays U.S. Aggregate Total Return Index Unhedged AUD; Global Bonds - Bloomberg Barclays Global-Aggregate Total Return Index Value Unhedged AUD; US High Yield - ICE BofAML US High Yield Index; EM Hard Currency - J.P Morgan Emerging Markets Bond Index Global Diversified (EMBIGD) - EMBIGD is unhedged. EBND will hedge its hard currency; EM Local Currency - J.P. Morgan Government Bond Index-Emerging Markets Global Diversified.
Looking ahead in the new world
Many EM economies are as structurally sound and well managed as developed market economies, and in many cases better. Current accounts and government budgets are largely in check. Policy makers, appealing to ever growing and better educated middle classes, are encouraging savings and pension reforms which is driving capital investment. Today, the new world of EM debt is characterised by higher foreign exchange reserves and lower spreads on bonds (relative to US Treasuries), as the chart below shows.
How EM bonds have changed
Source: Bloomberg, VanEck Data to 31 December 2019. EMBIG spread is the difference between EM hard currency sovereign bonds and US treasuries, and is captured by the JP Emerging Bond Index Global Sovereign Spread.
This contrasts with the “old world”, where two decades ago EM bonds were risky and volatile due to low reserves and the inability to absorb losses, coupled with a lack of transparency of financial information. This was typified by the 1997 Asian financial crisis and the 1998 Russian financial crisis then Argentina’s much publicised default in 2001. These crises set the scene for significant economic reforms through the early part of the new millennium. Many emerging markets were forced to be fully transparent with their data to garner support from foreign investors and global monetary funds, often for the first time. As a result many came out of the GFC structurally stronger than their developed market counterparts.
Drawdown
No investor wants to lose money and investors spooked by events over 20 years ago can look at a measure called ‘drawdown’ to determine how emerging markets bonds have improved. Drawdown demonstrates both the depth of a fall from a historical peak and the pace of the recovery to a new peak.
The chart below shows the drawdown of EM bonds versus other asset classes over the past 15 years capturing the GFC. You can see that falls by EM bonds were closer to developed markets bonds than equities during the GFC and the debt crises of ‘09 and ‘11.
Source: Morningstar Direct, Results are calculated monthly and assume immediate reinvestment of all dividends. You cannot invest in an index. Past performance is not a reliable indicator of future performance. Indices used Australian Bank Bills – Bloomberg Australian Bank Bill 0+ Yr Index, Global Bonds – Barclays Global Aggregate Bond Index A$ Hedged, Australian Bonds – Bloomberg AusBond Composite 0+ Yr Index, Australian equities – S&P/ASX 200, Global equities – MSCI World ex Australia Index, EM equities – MSCI Emerging Markets Index, EM Bonds – 50% JPM EMBI Global Diversified and 50% JPM GBI-EM Global Diversified EM Bond is 50% JPM EMBI Global Diversified and 50% JPM GBI-EM Global Diversified. This index is used to illustrate historical performance of the EM Bond market only. It is not the benchmark for EBND.
The income opportunity
Most Australian investors have been missing the opportunities presented by emerging markets bonds simply due to lack of access and understanding of where it fits in a portfolio. Until now it has been almost impossible for most investors to invest in bonds from emerging markets and equally challenging to take an informed view as to which bonds present the best opportunity.
However, the VanEck Emerging Income Opportunities Active ETF (Managed Fund) (ASX: EBND) offers a fully transparent, actively managed fund of emerging markets bonds and currencies that can be bought and sold on the ASX.
EBND has a targeted yield of 5% p.a.* and enables investors to access a globally diversified portfolio of emerging markets bonds via a single trade on ASX.
No member of the VanEck group guarantees the repayment of capital, the payment of income, performance, or any particular rate of return from EBND.
Published: 17 February 2020
