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Emerging Market bonds: why they belong in your portfolio

Image of the various currency flavours of emerging market bonds

There’s credible evidence that Emerging Market bonds are a useful diversifier in passive portfolios. Albeit in a very different role from the one that bonds traditionally play.

Instead of slotting into the defensive ramparts of your asset allocation, Emerging Market bonds belong on the growth side.

They may offer equity-like returns while lowering overall portfolio risk.

Sounds too good to be true? Let’s see…

The case for Emerging Market bonds

We were tipped off about the potential of Emerging Market bonds by Monevator reader and hedge fund quant – ZXSpectrum48k.

Regular readers will be familiar with ZX’s insights over many years. They’ve dropped into our comment sections like messages from a friendly extra-terrestrial, with access to technology far in advance of our own.

ZX’s thesis is:

  • Emerging Market US$ denominated sovereign bonds have historically produced better returns than Emerging Market equities.
  • They’ve done so while being much less volatile than Emerging Market equities. As such, they’ve inverted the standard risk-reward relationship for more than 20 years.

That sounds like a good deal. Especially as Emerging Market bonds exhibit lower correlations with global equities than Emerging Market equity.

And ZX isn’t alone in noticing the special properties of Emerging Market debt. Vanguard’s research paper Emerging-market bonds: a fixed income asset with equity-like returns (and risks) states:

Their strong historical returns and high yields, along with the improved economic fundamentals of their issuers, have generated investor interest in holding them as a distinct portfolio allocation…

…We find that emerging market bonds have performed more like equities than like bonds.

Emerging Market bond types

Emerging Market (EM) debt divides into three main categories:

  • Emerging Market US$ sovereign bonds – government debt and government guaranteed debt, denominated in dollars.
  • Emerging Market local sovereign bonds – government debt and government guaranteed debt, denominated in the issuer’s local currency. This local EM debt is typically more volatile and less diversified than its US$ counterpart.
  • Emerging Market US$ corporate bonds – corporate debt, denominated in dollars.

The three flavours diversify across Asia Pacific, Eastern Europe, Latin America, Africa, and the Middle East, in quite different proportions to Emerging Market equity index funds. Holdings include a blend of investment and sub-investment grade bonds (also known as junk bonds).

You could mix all three types, but that’s taking complexity too far. Emerging Market US$ sovereign bonds bestow the benefits we’re after. That’s also what ZX uses. 

The chart below is from JP Morgan. It shows EM US$ sovereigns sitting close to the efficient frontier that denotes the risk-return sweet spot. (Okay, it’s a curve not a spot. Shoddy journalism, I know…)

Emerging Market US$ sovereigns sit closest to the efficient frontier according to this JP Morgan chart

We’ll focus on Emerging Market US$ sovereigns for the remainder of this three-part series.

Emerging Market bonds: historical returns

The primary return drivers for Emerging Market US$ sovereign bonds are:

  • The credit risk of Emerging Market governments
  • Interest rate exposure to US Treasuries

The EM US$ sovereign bond market has existed in its contemporary form for just over 30 years. History therefore offers us fewer crumbs to crunch on than our usual century’s worth of Developed Market data.

Publicly available EM sources are also few and far between.

However the research does suggest that something is going on:

Emerging market bond returns versus other global assets in table form.

Source: Vanguard. “Emerging-market bonds: a fixed income asset with equity-like returns (and risks).” August 2018. Page 8. US$ returns (2002 – 2017).

Emerging Market US$ sovereign bonds beat all other asset classes including global equities and US equities during this period. Only US bonds bested EM sovereigns on a risk-adjusted basis.

Emerging market bonds returns and volatility versus other global asset classes in chart form.

Source: State Street. “Case for Allocating to Emerging Market Debt.” February 2021. Page 7. Euro returns (2002 – 2020).

This second graphic shows Emerging Market US$ sovereign bonds on the far left. It’s labelled as Hard Currency Sovereign Debt. Compare its turquoise drawdown bar against Emerging Markets Equity on the far right.

While equity returns nosed ahead, EM US$ sovereigns won on a risk-adjusted basis. They inflicted less than half the pain for a similar gain.

Emerging Market bond returns including the pandemic

That’s all very well. But has the pandemic torn EM government balance sheets a new one?

We can compare EM US$ sovereign bond returns versus Emerging Market equities using iShares ETFs.

Here’s the data from February 2008 up to June 2021:

Emerging Market bond returns vs Emerging Market equity chart Feb 2008 to June 2021

Source: justETF. (Cumulative GBP returns, income reinvested)

  • Emerging Market US$ sovereign bonds: +208% (Blue line).
  • Emerging Market equities: +118% (Red line).

As you can see, the EM debt idea has not been torpedoed by the pandemic.

Yes, there was a sell-off during the Coronavirus Crash of March 2020, followed by a moderate dip earlier in 2021.

But recent performance doesn’t suggest the market thinks that EM economies are being crushed.  

Emerging Market volatility during the Coronavirus Crash

Emerging Market bond returns vs Emerging Market equity during the coronavirus crash

Source: justETF. (GBP returns, income reinvested)

The lower volatility of EM US$ sovereign bonds relative to EM equities held up during the Corona Crash:

  • Emerging Market US$ sovereign bonds: -14% (20 February to 19 March 2020, blue line).
  • Emerging Market equities: -23% (20 February to 23 March 2020, red line).

Emerging Market volatility during the Global Financial Crisis

Emerging Market bond returns versus Emerging Markets equity during the Global Financial Crisis

Source: justETF. (GBP returns, income reinvested)

The lower volatility thesis for EM US$ sovereigns also delivered during the Global Financial Crisis. EM hard currency bonds dropped less than a third as much as EM equities when the market hit rock-bottom:

  • Emerging Market US$ sovereign bonds: -16% (18 May to 23 October 2008, GBP, blue line).
  • Emerging Market equities: -53% (18 May to 27 October 2008, GBP, red line).

Emerging Market bond returns including the 1990s EM Financial Crisis

I know what you’re thinking. What about the 1997-98 Emerging Market Financial Crisis? Surely the returns above all hark from the Noughties because the Asian Contagion of the previous decade strips this notion bare like a Chinese groom cling-filmed to a tree, in a pre-wedding hazing ritual? [Er, indeed… surely? – Editor]

Not so.

The Bogleheads are a wonderful online community of passive investors. And one of the Bogleheads’ key statistics wizards provided the following returns data over a period that also includes the 1994 Mexican Peso Crisis:

Sub-asset class Annualised return (%) Volatility (%)
Emerging Market US$ sovereign bonds 8.8 12.9
Emerging Markets Equities 5 31.5

Source: Bogleheads, JP Morgan Emerging Market Bond Index Global Diversified (JPM EMBIGD), MSCI Emerging Markets Index. US$ returns (1994 – 2018).

Yes, Vanguard and State Street could have an incentive to data-mine. They want to support their Emerging Market fixed income products.

But neither ZX nor the Bogleheads are trying to sell me anything. And I’m further reassured by their reminder that the evil twin of equity-like returns is equity-like falls:

ZX cautions:

As a fixed-income credit product, it’s definitely not low-risk. For example, the index dropped 21.8% between Jun ’08 and Nov ’08.

Meanwhile the Bogleheads point out that Emerging Market bonds dropped by 40% in 1998!

Buyer beware. If you need to find room for Emerging Market debt in your portfolio, please replace a percentage of your equity asset allocation. Do not swap out any of your defensive bonds.

Does this data hold up for UK-based investors?

I calculated annualised returns and volatility in GBP (pound sterling) terms for EM US$ sovereign bonds (1994 – 2021):

  • Annualised total return: 8.85%
  • Annualised volatility: 13.66%1

Source: JP Morgan EMBIGD index. Monthly sterling total returns (31 December 1993 – 28 May 2021).

The data is from the market-leading index. It runs from its inception date to the latest month available as I write.

In comparison to the earlier Vanguard numbers, return is down and volatility up. The gloss has come off a little.

But we are still looking at equity-like returns with lower volatility.

Portfolio diversification

The Emerging Market bond story stacks up so far. The bonds outperformed Emerging Market equities, on a historical risk-adjusted basis at least.

Good portfolio building materials include asset classes that add return and reduce overall volatility.

Portfolio-level volatility can be lowered by asset classes that offset each other’s performance. If Asset A rises when Asset B falls, then your portfolio’s volatility is reduced.

Correlation measures the closeness of the relationship between the prices of two such asset classes.

A correlation score of:

  • 1 means that the price of two assets rise and fall in lockstep.
  • 0 means there’s no relationship between the two. Think of a random walk.
  • -1 means one asset rises when the other falls, in perfect synchronicity.

According to State Street2, the correlation scores for Emerging Market US$ sovereign bonds were:

  • 0.49 with MSCI World equities
  • 0.4 with Emerging Market equities
    (January 2003 – December 2020)

So EM US$ sovereign bond prices tend to move in the same direction as the two equity classes above. However the relationship is relatively modest.

State Street calculated that Emerging Market equities correlation with MSCI World equities was higher still, at 0.76.

In other words, Emerging Market US$ sovereign bonds were a better diversifier than Emerging Market equities, in portfolios dominated by World equities.

Naturally, asset correlations aren’t static. That would be too easy. They change over time, and differ by data source.

However, Schroders’ correlation-check shows a similar, if less impressive relationship between EM US$ sovereign bonds and equities:

  • 0.6 with global equities
  • 0.7 with Emerging Market equities
    (December 2002 – December 2018)

EM equities were again more highly correlated with global equities, at 0.9.

Hat-tip to Monevator reader c-strong who shared the Schroders piece. (Note, Schroders labels it as marketing.)

How much difference do Emerging Market bonds make?

The Vanguard and State Street papers include back tests. And it’s fair to say a slug of Emerging Market sovereigns wouldn’t have changed your life.

Vanguard’s test is the least shonky. It shows a 0.5% increase (at best) in annualised portfolio returns (from 1993 to 2017).

Emerging Market bonds improve portfolio return and volatility - Vanguard backtest

Source: Vanguard. “Emerging-market bonds: a fixed income asset with equity-like returns (and risks).” August 2018. Page 11. US$ returns (1993 – 2017)

The lime green line shows the uplift that accompanies replacing progressively bigger wedges of equities with EM US$ sovereign bonds.

The plum line usually refers to The Accumulator’s telephone number. But in this case it shows that risk-adjusted returns are improved by larger EM debt dollops. 

Finally, we performed the first-ever Monevator backtest using our patented data-torturer methodology.

Okay, really I threw together a passive portfolio using the longest-running and most relevant ETFs I could find:

  • 10% iShares JP Morgan USD Emerging Markets Bond
  • 70% iShares MSCI World
  • 20% iShares Core UK Gilts

This portfolio made a cumulative gain of 227% from 15 February 2008 to 19 June 2021.

That’s a marginal improvement on the 217% gained if I substitute the EM bond ETF for iShares MSCI Emerging Markets Equity ETF.

If the grass is always greener, this is like moving from ‘moss green’ to ‘kale’ on the Pantone chart.

Emerging Market bonds: the underlying rationale

Asset classes must show more than juicy historic returns and hopes of lower volatility to justify their place in a passive investor’s portfolio. 

We also need a rationale. Something to explain why an investment can repeat that performance in the future.

ZX points out that EM US$ sovereigns are partly propelled by the carry trade:

It’s a classic carry product but backed by the fact that the debt fundamentals of most EM countries are in far better shape than developed market governments or, more importantly, the private sector.

Carry refers to the tendency for higher-yielding assets to deliver superior returns to lower-yielding assets. The carry factor is closely associated with currency markets. But it shows up in other asset classes, too.

Essentially, you can expect to earn a carry premium as compensation for investing in riskier, high-yielding assets versus safer, low yield assets.

But as with the equity risk premium, expected average returns are no guarantee of future returns. The premium may disappear, or not materialise in your investing lifetime. That’s the nature of risk. It’s not peculiar to the carry trade, of course.

As with any source of risk, the carry trade is a double-edged sword. It cuts both ways:

  • It’s moderately correlated with the stock market overall, and provides an additional source of diversification. 
  • But the carry trade is highly correlated with other risky assets during downturns. 
  • The carry premium is historically robust. It scores a moderately high average excess return, according to research
  • But it can inflict major losses during a crisis as capital flees to safe havens

You may well have exposure to other sources of carry, too, such as in high-yield corporate bonds3, and via EM equities, UK equities, Value, and Small Cap. 

Carry on investing

This piece is meant to be the case for Emerging Market bonds. I’ve saved the case against for part two. 

But I think it’s already clear the upside to reallocating to EM debt is likely to be marginal-to-vanishing for most Monevator readers. Especially if you’re a passive investor whose secret weapon is simplicity

Nevertheless I’m tempted

Vanguard’s backtest shows much improved risk-adjusted returns with Emerging Market bonds. That’s the main potential win.

The prospect of bagging a substantial discount to the swingy-ness of Emerging Market equity has me seriously thinking about a switch. Or perhaps giving half my EM equity allocation to EM bonds, as I do like the idea of a heftier diversification to the carry trade.

My main concern is the historic data may just reveal a one-off, golden period of outperformance. 

Emerging Market bond yields have fallen a long way since the dark days of the 1990s. Yields are always a key driver of bond returns. That ‘equity-like’ performance could be a thing of the past. 

I’ll get deeper into EM debt in part two. Get ready for enough downers to suck the soul out of Motown.

Take it steady,

The Accumulator

  1. Standard deviation []
  2. Case for Allocating to Emerging Market Debt. February 2021. Page 10. []
  3. Which share commonalities with EM market bonds. []
{ 15 comments… add one }
  • 1 Matthew July 14, 2021, 10:50 am

    On a risk vs reward comparison, how would you weigh up different risk-on bonds, ie EM US$ sovereign, Vs Global corporate bonds, Vs Global junk bonds?
    How would you split such an allocation – by market cap?

    I just assume that risk on bond exposure is contained within some of my equities.

  • 2 BillG July 14, 2021, 2:42 pm

    USD Emerging Markets Government Bond UCITS ETF (VEMT)
    has yield of 4.7, Average Mat 11.7Y, a duration of 7.5 and fees 0.25%
    Other ETFs are available.
    This will drop in value (all other things being equal) by 7% if rates rise 1.0%
    Where do we think rates are going?

  • 3 Haphazard July 14, 2021, 3:39 pm

    Lend money to the Chinese Government? To spend on ethnic cleansing?
    Not very attractive in ethical terms, perhaps. And perhaps investing in what the finance industry lamely calls “controversies” is financially risky, for the same reason. Surely more people may feel they can no longer turn a blind eye to the situation as more details come to light.
    I know some people say, they prefer to keep the ethics out of their portfolio and, one day, do good elsewhere (in proportion to the harm caused?). But surely there are some limits?

  • 4 Matthew July 14, 2021, 3:59 pm

    @Haphazard – Indeed China isn’t pure and I don’t know the breakdown of their spending, but I presume that on balance it does more moral good than harm – a lot of it is health, social care, welfare, infrastructure, education, etc.

    Of course we could say the same about N Korea, Iran, etc – they may be hostile, but as long as that doesn’t amount to conflict, has the military part of their spending actively done much harm? Apart from waste.

    There could be future sanctions, I suppose they might be priced in.

  • 5 NewInvestor July 14, 2021, 7:59 pm

    Interesting post, TA (what I understood of it). Now you have me all on tenterhooks awaiting part two (Emerging Market bonds: why they don’t belong in your portfolio) before I can decide if this diversification is for me or not. 🙂

  • 6 Hariseldon July 14, 2021, 11:57 pm

    What happened over the last 20 years or so does not reflect what will happen going forward, that ship has sailed.

    Look at the YTD, 1 , 3 and 5 year returns of Vanguard Emerging Government US$ Bonds VEMT versus the Vanguard Emerging Equity ETF VFEM.

    It does not suggest the bonds are more attractive than the equity, the Equity has posted far stronger performance over these recent periods.

  • 7 Hak July 15, 2021, 10:11 am

    I relation China, I believe Haphazard is referring to the current actions of the government in relation to the Uyghurs and the building of the surveillance state.

  • 8 Paul July 15, 2021, 2:56 pm

    Hi Acc,

    Would the Vanguard Emerging Market Gov bond fund (OCF 0.60%) produce what we are after as per your above post or the fact that this fund is hedged to GBP would that negate what we are seeking? Cheers Paul

  • 9 Dawn July 15, 2021, 8:45 pm

    Just when we’ve gotten our portfolios in order, monevator throws us a spanner in the works..I will read with intent part 2 ! Thanks for bringing to out attention.

  • 10 159F July 16, 2021, 1:49 pm

    Really not a huge amount of Chinese exposure in VEMT if one had concerns.
    Not too many places to get purely EM sovereign debt either.

    Also looking forward to the sequel…

  • Mogul
    11 The Accumulator July 17, 2021, 11:30 am

    @ Paul – it’s best to be unhedged. There are other, cheaper funds that can do the job – part 3 runs through the list and the things to watch out for.

    @ Dawn – 😉

  • 12 Onedrew July 17, 2021, 11:47 am

    Curses! I thought I was being clever when I bought £-hedged EMHG, the iShares J.P. Morgan $ EM Bond UCITS ETF.

  • 13 Ben July 17, 2021, 3:10 pm

    It doesn’t matter which holdings are in usd, just get the fraction right.

    Usd tends to outperform in a crisis as wealthy Americans repatriate their wealth for cash injections into their businesses and cover liabilities. The flight-to-quality is a myth. Anyway it creates a temporary excess demand that cushions the bottom a little.

    Looking forward to part II. I’ve got 5% in these bad boys

  • 14 c-strong July 17, 2021, 6:17 pm

    Coming rather late to this, had a busy week. Thanks for the hat tip!

    I’m still happy with my allocation to EMD – currently at 6% though I plan to increase it gradually to 8% once some HY UK retail bonds I bought in a fit of madness mature…

    After a lot of umming and ahhing, I went with local currency sovereign debt rather than USD (specifically the snappily named VanEck Vectors J.P. Morgan EM Local Currency Bond UCITS ETF – EMGB). I’ve seen quite a few different correlation numbers quoted, with some saying HC debt has a lower correlation to global equities than LC debt, but I think most said the opposite. As diversification is the main point of these things, I went with LC. But if ZX is in hard currency, that’s probably good enough reason to change 🙂

    I’ll be interested to see the other blog posts in the series!

  • 15 ZXSpectrum48k July 20, 2021, 7:48 pm

    @c-strong. I’m coming even later to this ….

    EM local currency is very much my day job these days. I see it as a great active asset class but not so great for passive investment. The problem with a passive allocation to EM local currency govt bonds is the same as for EM equities, in that the local currency exposure adds a lot of volatility for not so much return. Hence it tends to do look less attractive in a classical static asset allocation analysis.

    When you currency hedge those local currency bonds, the volatility drops massively and the return-risk ratio improves markedly (better than US$ EM debt). It starts to look much better. The problem is that currency hedging local currency EM bonds will erode the yield since EM interest rates, on average, are higher than G10 rates. This lowers the return on EM currency debt to levels which many would find too low for a “risky asset” in their portfolio. Of course, that’s because what is left once you take away the currency risk is GBP returns on some local govt bonds. Do you put that into the risky category because it’s EM or the riskless category because it’s currency hedged govt bonds? It’s a bit of a hybrid and different parts of that index will react differently to a stress environment. Some EM govt bonds collapse like equities, others rally like US Treasuries.

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