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Emerging-Markets Bonds Similar to Other Risk Assets

Mon, 30 Jul 2012

Although developing-markets debt purchases have been escalating of late, investors should be aware of the correlations to other assets as well as currency risks, says Morningstar's Eric Jacobson.

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Video Transcript

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Assets have been flooding into emerging-markets bonds, and many general bond managers have been adding them, too. Here to discuss the fundamental case for investing in emerging-markets bonds, as well as some pitfalls to watch out for, is Eric Jacobson. He is director of fixed-income fund research for Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Glad to do it, Christine.

Benz: Eric, there has been a lot of enthusiasm about emerging-markets bonds. Let's talk about why investors are finding this asset class to be increasingly compelling. What is the fundamental case for emerging-markets bonds?

Jacobson: The fundamental case has to do with the growth of emerging markets or better perhaps to say the maturity of them. By that I mean that a lot of the fundamental issues in emerging debt markets look a lot better over time than they used to, and that includes things like better growth in the emerging economies than we have in the developed economies.

We've all been talking about and hearing about the debt levels in the developed markets, such as our own and Europe and what a big problem it is. And in fact those debt levels are much lower in many of the emerging economies now. [There's been] a lot of hard work on the part of emerging nations in terms of their fiscal policies and what have you and just by comparison they look a lot better in some cases. You've also got the issue that there's a lot more issuance now than there used to be. The markets are more liquid and they're more diverse when you look at the breadth of emerging issuers that are out there.

Benz: Those are a couple of the key attractions, increased liquidity and in some cases, better fiscal pictures than developed economies. But let's talk about the potential risk factors for people delving into emerging-markets bonds and also whether you can safely supplant general bond types, general domestic bond types with emerging-markets bonds?

Jacobson: Well the first part of your question [focuses on] what some of those risks are, and for better or worse, the fundamental case looks terrific, when you pick apart all the data for emerging-markets debt. But the fact of the matter is, there are still risks inherent. One of them just by example is the fact that a lot of the newer issuance in parts of the market that are now getting into emerging-markets bond funds are local-issued debt rather than denominated in U.S. dollars, whether it's either sovereign or corporate. And in many cases there's extra currency risk there. Currency tends to be a pretty big volatility factor for bonds, if the risk is present, and it can overwhelm, or drown out if you will, the underlying attraction of holding just the regular bonds.

You also still have a general level of volatility whether or not you're talking even in the U.S. dollar market, which is still relatively large. Emerging-markets debt has been acting much like any other "risk asset" over the last couple of years. We've talked before about this tendency to have things, go risk-on and risk-off in different months, depending on what's going on in Europe, for example. Emerging-markets bonds tend to trade right along very much with high-yield bonds, and there's a pretty high correlation to equities and so forth. So, the risk factors are still there, things to worry about.

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Benz: Would you say then for investors who are thinking about that core fixed-income piece of their portfolio, that emerging-markets exposure is something that they want there? Do they want to think about that as sort of the aggressive kicker component of their fixed-income portfolios?

Jacobson: Yes, I think it's an evolving answer in the sense that we're starting to get to the point where the fundamentals are arguing in favor of sprinkling it into your portfolio even more and more perhaps than you would have 10 years ago, as an example, but I don't think we're quite there yet, in terms of a total replacement.

Now, there's a lot of question about this because we're at this turning point where people are starting to worry about rising rates and the low yields on core bond portfolios. For those folks, there might be a tendency to want to put a little bit more in high yield and emerging markets, but just, it's really important to keep in mind what I said before about the correlations, the currency risks, and the just higher level of volatility overall.

Benz: If you are shopping for emerging-markets bond exposure, it sounds like you're saying, figure out what sort of currency policy is going on there? Is it investing in the locally denominated debt or U.S. dollar-denominated debt? What are the other questions that should be on your mind as you are thinking about adding this type of exposure to your portfolio?

Jacobson: For emerging markets in general, but really, especially in the case where you've got debt issued in local currency and corporate debt as well, you really want to have a sense that your manager has a lot of experience in these markets because for better or worse, there are still things about many of them that are different. Even though many of them have higher-quality ratings than they used to, they have different local norms and traditions, whether it's legal or corporate and so forth, and you want to make sure you've got a management team that has some sense of how these things work and know which countries tend to be riskier and less risky in those situations.

Benz: My last question for you, Eric. Are you more comfortable recommending emerging markets embedded in the context of a broader fund where a manager has a lot of leeway to venture into emerging markets and maybe some other parts of the bond market as well?  Or do you like the idea of people adding dedicated emerging-markets exposure?

Jacobson: In my mind it kind of depends on whether or not the core manager that you're talking about, the broad mandate manager you're talking about, has a lot of expertise in-house or not. So, if you're dealing with a firm that is primarily known for its domestic-bond portfolios and maybe just has recently added emerging-markets capabilities or doesn't have that experience of an emerging-markets team, I'd rather go with the dedicated fund.

Vice versa, examples like PIMCO, obviously the big one out there. PIMCO has a pretty well established, embedded emerging-markets team. So, I don't mind seeing that pop up so much in their broad mandate portfolios. But if it were another firm, I might say, you know, I don't want to see them there. That's not the place I want to get that exposure. I want to go somewhere where they have a dedicated fund.

Benz: OK, Eric. Well, thanks as always for sharing your insights. This has been an area of great interest for investors, and I expect that it will continue to be. So, thank you so much for being here today.

Jacobson: Glad to do it. Thanks, Christine.

Benz: Thanks for watching, I'm Christine Benz for Morningstar.com.

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