Emerging Market Bonds Still A Buy

Should you invest in emerging market bonds?

Kristin Ceva says emerging markets are likely to keep creditors happy.

Americans have poured billions of dollars into emerging market bond funds this year in their global search for high yields. Are they setting themselves up for disaster as developing countries revert to their bad old habit of stiffing foreign creditors?
Not likely, says Kristin Ceva, comanager of the $635 million (assets) Payden Emerging Markets Bond Fund. Ceva, who holds a Stanford Ph.D. in international politics and studied Mexico's financial system as a Fulbright scholar, undoubtedly has an interest in talking up emerging markets. But she also makes an impressive case that they offer attractive fixed-income deals relative to the U.S.

The balance sheets of many developing countries' governments, she notes, are far healthier than Uncle Sam's. Total emerging market government debt averages less than 50% of gross domestic product, compared to more than 100% for the G3 (the U.S., Europe and Japan). Meanwhile sovereign emerging market bonds (about half of which are investment grade) are paying around three percentage points more than the 2.5% investors can earn from the comparable ten-year U.S. Treasurys.
"On any measure of debt sustainability, whether it's GDP, overall debt levels or GDP growth, the emerging countries are about twice as good as what you're seeing in developed markets," says Ceva.
There are risks, of course. Many of the countries Ceva is investing in have defaulted or restructured debt in recent years. The Asian financial crisis sent the value of emerging debt into a tailspin in 1997. A year later Russia defaulted on its domestic debt and halted bank payments to foreign creditors. The Dominican Republic restructured its foreign debt a mere five years ago.
Another reason for caution is that the popularity of emerging market bonds itself increases the risks. Americans have hiked their holdings of emerging market debt nearly sevenfold over the past decade to $34 billion, including a $5 billion inflow this year alone, according to Lipper Analytics. It's probably no coincidence that during that time emerging market bond funds have returned an annual average of 11.5%, or more than twice the 5.2% bond fund average.

Investing

As prices have risen yield spreads over Treasurys have narrowed for sovereign emerging market bonds. Their three percentage point yield premium means the emerging bonds are hovering close to their long-term average but double where they were during the frothy precrash days of 2007.
Pricing may not yet be flashing red, but there are other concerns. Foreign investors have gotten fleeced in the past as inflation in places like Brazil and Turkey has undermined the value of local currencies relative to the dollar. Investors can limit such risk by buying greenback-denominated "dollar pay" bonds. Owners still get burned, of course, if the issuer fails to come up with the dollars to honor its debts. That helps explain why spendthrift Venezuela was forced to offer a whopping 15.25% coupon in August to unload $3 billion worth of dollar-pay bonds.
So far, the dollar-pay pool is shallow, with only about $500 billion worth outstanding. That compares to $2.5 trillion worth of local denomination emerging market bonds, Ceva says.