Investing Knowledge

A couple of weeks ago fellow Fool writer Harvey Jones extolled the virtues of emerging market equities. I reckon he's bang on the money with that view; in the long term economic growth will be strongest in those countries. And when economic growth soars, stock markets usually anticipate, delivering tasty returns.

But there's another emerging market story that is less often heard about. In fact it's downright neglected even by UK fund managers: emerging market bonds. 

Juicy yields and decent capital growth with less volatility means I'm recommending them for the less risk averse income investor.

Not a good reputation

Part of the reason why emerging market bonds have been neglected is that there have been some shocking experiences over the last twenty years or so -- and bond market investors have long memories.

For example, in 1998 Russia decided to default on its government debt. The Asian financial crisis led to many problems including currency depreciation, which further reduced returns for UK investors.

In the latter half of the 1980s, Brazil abrogated inflation-indexation clauses embedded in its debt contracts. Even in the last decade Argentina issued inflation index-linked debt, then a couple of years ago fired their head statistician and changed the inflation rate calculation. By 1998 'official inflation' was 10%. Anyone who had a slide rule knew it was closer to 30%. Understating the inflation rate in this case is arguably a form of default.

In the Great Depression even the US government revalued gold from $20 to $35 per ounce, thereby rewriting its debt contracts for foreign investors.

But times change. Ten years ago only 10% of emerging market debt was considered 'investment grade', now that figure is closer to 50%. Brazil was raised to investment grade last year. So let's take a look at some of the positive drivers for emerging market bonds.

A good response to the economic crisis

Many of the factors present in the economies of mature countries were absent in emerging economies. They therefore entered the global recession in much better shape than in past crises. In fact, most of them never experienced recession.

The long term transition of emerging countries into developed countries gives rise to two potential gains. First capital (FCAP - news) gains as bond yields converge (decline) with developed markets. Second currency appreciation.

Although the recent recession indicates a relatively negative global outlook, there is little expectation of increasing default levels because many emerging economies have built up good current account surpluses.

Foreign exchange reserves have increased tremendously, providing stability to the exchange rate and avoiding the hyper inflation and currency depreciation that massacred bond holders in the past. Many emerging economies have even recognised the importance of an independent central bank.

As all of us in the UK are aware, current stimulus plans will plunge us into a debt our grandchildren will still be repaying. Not so in many emerging economies. China, for example, is spending from surpluses.

Risk and return characteristics remain tempting

Unlike a lot of other asset classes there still appears to be value in emerging market bonds. Yields approaching 7% are available from broadly based ETFs and provide a massive premium to gilts and US Treasuries given the financial potential and the economic factors mentioned above.

Returns on emerging market bonds compare favourably with other assets as the table below (from Morgan Stanley (NYSE: MS - news) data, 2002 - 2009) shows. OK so you'd have done better with emerging market equity, but some of us don't like that amount of volatility and emerging market equity funds pay no, or minimal, dividends.

Over the last three years emerging market debt has delivered 12.2% with a standard deviation (volatility) of 15.3%. That compares with an annual 3.3% return on emerging equity with an eye watering 32.2% standard deviation.

As I said at the start of this article, emerging market bonds are a neglected asset. The proportion of investor funds in this market are a tiny fraction of that invested in developed fixed interest markets. As this is corrected there is potential for positive price action based on increased demand. And if you don't believe the demand story, you really shouldn't be in either emerging market equities or bonds.

A limited choice

The problem for the on-shore UK investor is the limited number of funds available (which all lurk in the far too general IMA Global Bonds sector). The four actively managed funds that are available are: Investec Emerging Markets Debt, Threadneedle Emerging Emerging Market Bond, Baillie Gifford Emerging Markets Bond, and M&G Emerging Markets Bond. 

There is also an iShares ETF that tracks emerging market bonds. I haven't decided where to put my money yet but in an under researched area like this I'm tempted to split my investment between passive and active funds.