Hidden risks in emerging-markets debt?

Are emerging-debt markets able to accommodate these crowds? The International Monetary Fund's semiannual Global Financial Stability Report highlighted a number of trends on the topic. While the growing presence of foreign investors has contributed to the development and expansion of emerging-debt markets, this has also resulted in the asset class' greater sensitivity to changes in global appetite for risk. In particular, retail investors, as well as non-emerging-markets specialists, are more susceptible to herding behaviour, which can further amplify volatility during periods of sudden market shocks.

Another key issue is the increasingly restrictive regulatory environment across the world, which has served to reduce liquidity and dealer inventory in global bond markets. Global banks are less active in making markets in bonds, and hedge funds are trading less. This decline in market liquidity in emerging-markets bonds might serve to exacerbate volatility during periods of stress. While the conclusions of this IMF paper focused primarily on policy recommendations, the takeaway for investors is that global portfolio fund flows are likely to add a unique dynamic and risk (in addition to credit, duration, inflation and currency risk) to emerging-markets debt.

The U.S. Federal Reserve's announcement regarding the tapering of its asset purchase program in May 2013 and the resulting market volatility likely prompted the IMF's research into this topic. From early May through the end of June 2013, hard-currency (bonds priced in U.S. dollars or euros) and local-currency emerging-markets debt fell 9% and 10%, respectively, as measured by the J.P. Morgan EMBI and JP Morgan GBI EM Indexes. These sharp declines reflected the markets' concern that a tightening of global liquidity could stem the flows into emerging markets, which in turn might further weigh on a weakening growth environment in the developing world.

This shock helped expose the pockets of fragility within the emerging-markets universe -- namely Indonesia, India, South Africa, Turkey and Brazil. These countries all exhibit some combination of high inflation, weakening growth and rising current-account deficits. They experienced sharp foreign portfolio outflows and rapidly declining currencies through the summer of 2013. But over the past nine months, the equity markets of India and Indonesia have rallied strongly, not on improving fundamentals, but on the promise of reforms by newly elected leadership in both countries. Brazil has staged a much smaller recovery, in part due to the carry trade, as real interest rates in Brazil are currently significantly higher than those in the developed world. Extremely low rates in the developed world continue to support foreign investors' risk appetite, which has in turn helped support these recent trends.

This complacent attitude may be masking growing risks. It is true that defaults and devastating financial crisis are much less likely than they were just 20 years ago. Thanks to low market volatility, risk appetite is high and investors continue to reach for yield. Even if Canada and the U.S. begin to raise interest rates in the coming years, it is likely that Europe and Japan will keep rates low for a longer period, which may help sustain the relative appeal of emerging-markets bonds. If excessive risk-taking continues to drive inflows in the coming years, investors may want to heed some of the concerns highlighted by the IMF. A major shock, such as a sudden spike in oil prices or a financial crisis in China, could prompt very large outflows that could be more damaging to the asset class than the "taper tantrum" of 2013.

Investment options

Retail investment products that specialize in emerging-markets debt are a relatively new thing in Canada. At present there are only three exchange-traded funds and eight mutual funds sold locally that target emerging bond markets, all of which were launched less than five years ago. There are many ETF options sold in the United States, and our passive strategies analysts currently cover five ETFs in this category. However, currency effects become a bit complicated for Canadians investing in these U.S. products.

The three Canada-sold ETFs -- BMO Emerging Markets Bond Hedged to CAD ZEF, First Asset Morningstar Emerging Markets Composite Bond Index EXM and iShares JPMorgan USD Emerging Markets Bond C$-Hedged XEB -- all contain issues that are denominated in U.S. dollars, and all hedge their currency exposures back to Canadian dollars. This means these funds carry no currency risk. The iShares fund also has a version that trades in New York under the symbol EMB. Another U.S.-sold ETF that focuses on U.S.-dollar emerging markets bonds is PowerShares Emerging Markets Sovereign Debt PCY.

Hard-currency sovereign emerging-markets bonds are currently yielding around 5% (as measured by the J.P. Morgan EMBI Index), reflecting about a 260 basis points spread over U.S. Treasury bonds. Like the rest of the credit universe, spreads are low relative to history and have narrowed as a result of investors' demand for higher-yielding instruments. It is also important to note that hard-currency emerging-markets bond funds may be more sensitive to rising rates as they have average durations of seven to eight years, which is longer than the average high-yield or global-bond fund's duration of about 4.4 years.

Hard-currency emerging-markets bond ETFs

		Symbol	12-month yield (%)	Effective duration (yrs)	3-year annualized return*
	BMO Emerging Markets Bond Hedged to CAD	ZEF	4.80	8.00	6.4%
	First Asset Morningstar Emerging Markets Composite Bond Index	EXM	4.58	6.15	n/a
	iShares JPMorgan USD Emerging Markets Bond C$-Hedged	XEB	3.87	7.07	5.3%
	iShares JPMorgan USD Emerging Markets Bond¹	EMB	4.39	7.07	5.7%
	PowerShares Emerging Markets Sovereign Debt¹	PCY	4.53	8.89	6.7%
	*Returns as of Sept. 2, 2014 ¹Figures are in U.S. dollars Source: Morningstar

There are no ETFs in Canada that invest in local-currency emerging markets bonds, but the three funds in the table below are sold in the U.S. and are covered by our analysts. Spreads on local-currency sovereign debt are a bit more difficult to evaluate because yields are primarily driven by local monetary policies and yield curves. Over the past year or two, local-currency sovereign debt yields have trended higher as governments sought to address higher inflation and other imbalances in their respective economies by raising rates. While local-currency-denominated funds tend to have shorter durations of around four years and slightly higher yields relative to their hard-currency peers, investors need to consider if they are being fairly compensated for taking on added foreign currency risk; not only is the performance of these funds affected by fluctuations between the U.S. dollar and the local currencies in which they invest, but for Canadian investors there is an extra layer of currency risk resulting from variations between the U.S. dollar and the loonie.

Local-currency emerging-markets bond ETFs

		Symbol	12-month yield (%)	Effective duration (yrs)	3-year annualized return*
	Market Vectors EM Local Currency Bond ETF	EMLC/NYS	5.39	4.48	0.0%
	WisdomTree Emerging Markets Local Debt ETF	ELD/NYS	3.30	5.07	-0.8%
	iShares Emerging Markets Local Currency Bond	LEMB/NYS	2.45	4.32	n/a
	*Returns as of Sept. 2, 2014 Figures are in U.S. dollars Source: Morningstar

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