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…)
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:
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.
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:
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
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
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).
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
