As interest rates reach new lows, U.S. government and even corporate bond yields look bleak. To compensate, income-seeking investors are moving their money into riskier, higher-yielding debt--such as emerging-markets bonds. Among Morningstar fixed-income categories for funds, the emerging-markets-bond category was the best-performing in August, making it the monthly leader for the first time since June 2020.
Here, we explain more about emerging-markets bonds and some of the risks that investors may want to keep in mind.
Emerging-markets bonds are fixed-income instruments issued by countries with developing, often fast-growing economies. Emerging-markets bonds are issued in two main formats: local currency (sovereign bonds issued by the government of Mexico directly in pesos, for example) and hard currency (the same kind of Mexican government bond issued in U.S. dollars or the currency of another “developed” market).
The hard-currency emerging-markets-debt space is a common choice for investors seeking exposure to emerging markets without adding currency risk. To better understand this market, we analyzed the Morningstar Emerging Markets Bond Index. This index measures the performance of both corporate and sovereign bonds from over 60 emerging-markets countries, all issued in U.S. dollars. The index is market-cap-weighted, with capping constraints to ensure diversification. China, the second-largest economy in the world, currently makes up nearly 20% of country risk exposure.
After a stretch of losses, emerging-markets bonds edged into positive territory for the year to date. The Morningstar Emerging Markets Bond Index has been steadily picking up speed since hitting a low point in April 2021, outpacing the Morningstar Global Core Bond Index (made up of developed markets and investment-grade debt) by an increasingly wide margin.
When emerging-markets-bond returns started to increase, U.S. interest rates had already begun to fall. Lower interest rates tend to lure investors to pursue higher-yielding investments such as emerging-markets bonds.
A look at select Morningstar fixed-income indexes reveals that emerging-markets bonds have brought in higher yields than U.S. and global core bonds by a wide margin:
With the higher yields come higher credit risk. The Morningstar Emerging Markets Bond Index carries an overall credit risk rating of BBB, one level above junk-bond territory. Compared with the Morningstar Global Core Bond Index, which maintains a much higher AA credit rating, rating agencies often consider emerging-markets-debt instruments to be much riskier than developed-markets fixed-income securities. It is important to note that some countries classified as “emerging markets” have credit ratings equal to their developed-markets counterparts. Here’s the credit breakdown of each index:
Geopolitics, changing regulations, and macroeconomic factors can all play into this risk, adding volatility to both corporate and sovereign bonds from issuers in emerging markets. During the coronavirus pandemic, a stressful time for markets across the world, five emerging-markets countries defaulted on their debt payments (more defaults in one year than any other single year in history). And when emerging-markets bonds are denominated in their local currencies as opposed to hard currencies, additional currency risk is layered on top.
All this added volatility can make emerging-markets bonds behave more like equities, especially during downturns. In March 2020, when the markets took a nosedive, the Morningstar Emerging Markets Bond Index lost over 12%, closer to the Morningstar U.S. High Yield bonds’ losses of over 20% than to the losses of their global and U.S. core bond counterparts’ losses of less than 5% each.
Emerging-markets bonds’ comparatively risky profile is nothing new. As Morningstar analyst Neal Kosciulek states, “The return investors reap isn’t likely to be commensurate with the risk.” Over the last 10 years, emerging-markets bonds carried the highest standard deviation (a measure of volatility) and the steepest drawdowns compared with their global and U.S. core bond counterparts, but they also earned higher returns than other areas within fixed income. Despite their risks, emerging-markets bonds can still have a role to play in the diversified portfolio.