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By Paul Justice, CFA | 08-09-2012 01:00 PM

Arnott: Emerging Markets Are Today's Low-Hanging Fruit

The Research Affiliates chairman discusses why he see value in developing-markets bonds as well as the urgency for investors to build a 'third pillar' in their portfolios.

Paul Justice: So earlier you mentioned a lot of interest in emerging-markets bonds, which I think is an appealing section of the market, especially for most investors who don't have much exposure there at all. But we have seen a lot of asset flows coming into this area and the growth of these markets. When would you become concerned that this has been too much, too fast?

Rob Arnott: Emerging-markets bonds are interesting to us because of the yield spread. That means, that when the yield spread collapses that's our clue that there has been too much flow. What we've had is a lot of talk about interest in emerging-markets bonds. The flows have not been vast. And so what we see is emerging markets collectively in aggregate, they are 40% of world GDP, they are 10% of world’s sovereign debt, well that's neat. The G5, the five largest developed economies of the world, they are the same size; five countries, 40% of world GDP, but they are 70% of world’s sovereign debt.

So emerging economies have 7 times of the debt coverage ratios of the G5 and yet they pay 3% to 4% higher yield. Well, that's interesting. Furthermore you can invest in them in their local currency, garner a premium yield, and if we turn on the printing presses and debase the currency in order to monetize the debt, which I think is high odds for next year, then we're invested away from a falling dollar. So I see it as an interesting area on multiple levels. I think emerging-markets debt is about as close as we come to low-hanging fruit these days. To be sure, a 5% yield is not a brilliant yield, but again it's an expectations gap.

Justice: I must confess, it's a compelling argument when you think about debt as almost a cap-weighted concept that most investors are buying from the people who issued the most debt. That's where most of their portfolios are going to fall. And this underweight to emerging markets seems like a pretty good opportunity, given that valuation context.

Arnott: I think that's exactly right. PIMCO has their GLADI concept, Global Advantage Bond Index, which weights bonds according to GDP. We have our fundamental index in bonds, which weights bonds according to various measures of economic footprint--GDP, size of the population, size of the land mass of the country, energy input into the macroeconomy, these multiple measures.

And whichever approach you use, you wind up not being drawn in to buying more debt just because somebody issues more debt. Even in the emerging markets, we see pockets of concern. Mexico and Brazil have debt burdens that are fast approaching those of the developed world. Well that's a yellow light. It's not a red light; it's a yellow light. It's a caution. So ramping that [weighting] down because their GDPs are not rising more rapidly than the rest of the emerging economies of the world is an interesting way to deal with that problem.

Justice: I guess I won't put you in the bear camp; I'll put you in the cautious camp. Thank you for sharing a lot of good ideas for alternatives for people instead of just going with a traditional approach of asset allocation in a broad portfolio.

Arnott: I think most investors have the lion's share of their money in mainstream stocks and bonds, and they urgently need to build a third pillar because in a reflationary regime, those two pillars--stocks and bonds--both crumble. Building that third pillar is I think an urgent need right now and far too few people have a third pillar.

Justice: Great. Well, thank you so much for those insights today. Thank you for joining us, as well. I'm Paul Justice for Morningstar.

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