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Emerging Market Bonds


Traditional Mom & Pop, Apple Pie Pension Plan thinking is that the purpose of bonds in the institutional investment portfolio is to provide an offset against future pensions to be paid to pensioners. The stream of interest payments that the bond pays out look a lot like the pensions that have to be paid out. The future liability is calculated based on bond yields so both the assets (bonds) and future pensions (the liabilities) move in tandem. When bond yields move up, bond prices move down but pension plan liabilities move down too. So interest rate risk is somewhat negated. That’s why pension plans have a large strategic allocation to domestic (Canadian) bonds.

Non-Canadian bonds have interest rate risk AND currency risk which has made them more of a tactical play. But Emerging Market Bonds (EMB’s) might be an opportunity to significant to ignore.

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The case for emerging markets (EM) is well documented (and marketed). According to Haver Analytics and RBC Asset Management, emerging markets contribute 47% to world GDP growth. Favourable Government debt-to-GDP ratios, stronger fiscal positions, increasing per-capita income, reduced variability in economic performance as well as significant human capital development and rapid productivity increases are some of the EM characteristics that describe a sustainable growth story. Further, EM debt is being put to productive use like building infrastructure. (European debt, in contrast, is being used to finance consumption).

The opportunity in EMB’s is in the Trillion’s (JP Morgan EMBi, CEMBi and GBi-EM indexes combined) and growing fast. (see table). This compares to the Canadian (DEX Universe) bond market size of $1.1 Trillion.

EMB yields and credit ratings

EMB yields are ~4.5% above US Treasury yields (currently about 2% + 4.5% = 6.5%). (EM Corporate bonds yield another 0.50%-0.75%).

EMB credit ratings have steadily improved and hover around the investment grade cut-off of BBB.

Emerging Markets bonds

chart source: JP Morgan

Correlation of the JP Morgan EMBi to the S&P/TSX stock index is -0.10%. Negative correlation is tough to find. Even the Canadian (DEX Universe) bond index correlation to the S&P/TSX is only 0%. Source PHN.

Volatility

Emerging market debt overall has roughly one-half the volatility of emerging market equities. (source PHN).

Risks

Emerging markets are those from which one cannot emerge in an emergency!” – James Cross, Deputy Governor, South Africa Central Bank, 1998.

Individual investors should consider a safety first approach.

Emerging stock and bond markets are growing and evolving (emerging?) so fast that using historical data to look forward and make predictions with requires a leap of faith.

Seasoned investors will recall the early 1980’s and mid 1990’s EM currency crisis’s that hit foreign bond valuations (and allocations) severely.

Individual investors today need to be reminded of the risk and return relationship. EMB’s yield more than domestic bond yields because … they are riskier.

EMBi CEMBi GBi-EM DEX Universe

Market size Jan/12 $276 B $213 B $864 B $1.1 T
Credit rating BBB or >  53% 73% 85% 100%
# Countries 43 30 16 1
# Issuers 73 174 17 219
Currency exposure US$ US$ Local currency C$

EMBi = JP Morgan Emerging Market Bond index. CEMBi = JP Morgan Corporate EM Bond index. GBi-EM = JP Morgan Government Bond index EM (unhedged). (High yield bonds not included). DEX Universe Bond index = Canada bonds C$.

Source: JP Morgan, PHN

Implementation.

Individual investors don’t do credit analysis research on individual bonds. The only safety first approach to investing in foreign bonds is through indexing or Exchange Traded Funds (ETFs). For most individual investors, this is likely the case for all bonds but especially for foreign bonds as few investors are equipped to interpret foreign accounting rules, terminology or other idiosyncrasies (or language). (Not to mention the complication of ‘how, where and when to buy and at what cost?’).

An ETF investor can narrow foreign bond choices into three sub-asset classes. US$ EM Government. US$ EM Corporate and Local (EM) currency bonds. Foreign exchange exposure is the critical differentiator between them.

As always, when there is a mad rush to safety … the safe haven is likely to be to US$. So EMB in US$ will be somewhat buffered (as EM currency drops relative to US$, the EM bond, if US$ denominated, provides some offset).

No currency risk

Investors can avoid currency risk altogether with the BMO Emerging Markets Bond Hedged to CAD ETF (ZEF) which replicates the Barclays Capital Emerging Markets Tradable US$ Sovereign Bond Index CAD Hedged.

US$ currency risk

Investors willing to accept US$ currency risk could consider ETFs that mimic US$ EMB indexes EMBi and CEMBi. For US investors, there is no currency risk. For Canadian investors there is only US$ currency risk.

The iShares JP Morgan EMBi is a US$ index and the mirroring ETF is (EMB).

The iShares JP Morgan US$ EMBi ETF hedged to C$ (XEB)  works for those investors not willing to take any US$ currency risk.

Local (EM) currency risk

For those free-spirited investors that don’t mind EM currency risk, there is the JP Morgan GBi-EM local currency bond index. (The market is larger and more liquid than the above US$ bond indexes). The most likely ETF is the SPDR Barclays Capital Emerging Market Local currency Government Diversified Bond ETF (EBND).

Even after diving deeper into the data (and despite receiving a couple of nasty e-mails) I’m still not sure about a strategic allocation for pension plans. All three JP Morgan EM bond indexes have significant exposure below investment grade (BBB). But the case for a tactical EMB allocation grows stronger.

Next time? More Risk Management.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan
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