What are emerging market bonds?
Emerging market bonds—fixed-income bonds issued by developing economies and companies in these countries—have become increasingly popular in investor portfolios in recent years. Their attractiveness is attributed to the continuous improvement in credit quality and higher yields of these bonds relative to US corporate bonds and Treasury bonds. However, higher returns are often accompanied by higher levels of risk, and emerging market issues often bring higher risks than domestic debt instruments.
- Emerging market bonds are debt instruments issued by developing countries.
- These bonds tend to have higher yields than U.S. Treasury or corporate bonds
- Direct investment in emerging market bonds can be difficult, but most U.S. mutual fund companies have a variety of emerging market fixed income funds to choose from.
- An investment tool that can protect bondholders from default risks in developing countries or foreign companies is credit default swaps (CDS).
Understanding emerging market bonds
For most of the 20th century, emerging economies only issued bonds intermittently. However, in the 1980s, Nicholas Brady, then Treasury Secretary, began a plan to help the global economy restructure its debt through the issuance of bonds, mainly denominated in U.S. dollars. In the next two decades, many countries in Latin America issued these so-called Brady bonds, marking an upward trend in the issuance of emerging market bonds.
As emerging debt markets began to grow and more foreign markets began to mature, developing countries began to issue bonds in U.S. dollar denominations and domestic currencies more frequently; the latter were called “local market bonds.” In addition, foreign companies began to issue and sell bonds, which promoted the development of the global corporate credit market.
The expansion of emerging market bonds coincides with the maturity of the macroeconomic policies of these developing countries, such as the implementation of cohesive fiscal and monetary policies, which gives foreign investors full confidence in the long-term stability of these countries. As investors begin to take action on the increasing reliability of developing countries’ economies and the increasing diversification of bond issuance, emerging market bonds have risen to become the main fixed-income asset class.
Today, bonds are issued by developing countries and companies around the world, including Asia, Latin America, Eastern Europe, Africa, and the Middle East. In addition to Brady bonds and local market bonds, the types of fixed income instruments also include Eurobonds and Yankees bonds. Emerging market bonds also offer a variety of derivatives, as well as short-term and long-term bonds.
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If you decide that the potential return offsets the potential risk of investing in emerging market bonds, there are many options, although there are some limitations. When investing in emerging markets, in many cases, it is impossible or extremely unlikely for individual investors to directly invest in bonds in developing countries or bonds issued by foreign companies. However, most U.S. mutual fund companies have a variety of emerging market fixed income funds to choose from.
These funds can choose to issue bonds denominated in U.S. dollars and/or local currencies from developing countries and companies. Some funds invest in diversified emerging market bonds from all over the world, while others focus on regions such as Asia, Eastern Europe or Latin America. In addition, some funds only focus on government-issued or corporate bonds, while others have a diversified portfolio. Some funds track one of the many indexes that follow the performance of emerging market bonds, the most famous being the JPMorgan Chase Emerging Market Bond Index (EMBI Global).
An investment tool that can protect bondholders from default risks in developing countries or foreign companies is credit default swaps (CDS). CDS has the ability to protect investors by guaranteeing the face value of the debt in exchange for cash in the underlying securities or equivalent, if the country or the company fails to meet the debt.
However, while credit default swaps protect investors from potential losses, the rapid growth of the credit default swap market in certain developing countries often indicates that there is growing concern that the country (or companies within the country) may not be able to repay debt Therefore, lower agency ratings and a country’s credit default swaps’ base point increase are seen as red flags for specific emerging markets and their ability to repay debt to investors.
Pros and cons of emerging market bonds
Despite these risks, emerging market bonds still provide many potential returns. Perhaps most importantly, they provide portfolio diversity because their returns are not closely related to traditional asset classes. In addition, many investors who wish to offset currency risks in other portfolios choose to invest in emerging market bonds issued in local currencies as a valuable tool for hedging this risk.
In addition, developing countries also have a trend of rapid growth, which usually increases returns. For this reason, among them, the yield of emerging bonds has historically been higher than that of U.S. Treasury bonds.
Investors often track the yields of U.S. Treasury bonds and emerging market bonds, and look for expanded spreads or additional yields that emerging market bonds can provide at any given time. The higher the basis point spread of the yield (that is, the higher the yield of emerging market relative to national debt), the greater the attractiveness of emerging market bonds relative to national debt as an investment tool, and the more investors are willing to bear another The inherent risks of emerging market bonds.
The risks of investing in emerging market bonds include standard risks that accompany all debt issuance, such as variables in the issuer’s economic or financial performance and the issuer’s ability to meet payment obligations. However, these risks are exacerbated by potential political and economic fluctuations in developing countries. Although emerging countries have made great strides in limiting national or sovereign risks as a whole, it is undeniable that the possibility of social and economic instability in these countries is greater than that of developed countries, especially the United States.
Emerging markets also bring other cross-border risks, including exchange rate fluctuations and currency devaluations. If the bond is issued in a local currency, the exchange rate of the U.S. dollar to that currency will have a positive or negative impact on your yield. When the local currency strengthens relative to the U.S. dollar, your returns will be positively affected, and a weak local currency will adversely affect the exchange rate and negatively affect yields. However, if you don’t want to take currency risks, you can invest only in bonds denominated in or issued only in U.S. dollars.
Emerging market debt risks are assessed by rating agencies, which measure the ability of each developing country to meet its debt obligations. Standard & Poor’s and Moody’s ratings are often the most widely watched rating agencies. Countries with a rating of “BBB” (or “Baa3”) or higher are generally considered investment grade, which means that it is safe to assume that the country can make payments on time. However, a lower rating indicates speculative-grade investment, indicating that the risk is relatively high and the country may not be able to meet its debt obligations.