Emerging Market BondsBond Instruments
Emerging market bonds are highly risky compared to stable first world equivalents. These nations are nowhere near as developed as the first world nations, so they are far more vulnerable to economic shock. The issues of sovereigns from the second or third world are highly volatile and more likely to default than first world issues.
Emerging market sovereign issues are unstable thanks to potential problems with poverty, political instability, and economics. During periods where these are on the rise the bonds are also highly illiquid. Companies from these markets also suffer from these problems, but they additionally compete with international firms who do business in their market. If there is a problem with these markets it will be difficult for you to find another investor to purchase these bonds, sovereign or corporate. Illiquidity leads to low transaction frequencies, which in turn leads to a lack of price updates. Volatility appears artificially low and the lowered amount of price updates deceives investors. Emerging market bonds are often more volatile than their pricing suggests. A downturn in emerging markets can result in substantially more defaults than you would encounter from a similar downturn in a developed market.
Another problem is developing world currencies are not always stable. The currency can decrease in value over the term of a bond issue. Bondholders would be receiving payments low in value after currency conversions.
Since second and third world nations have economically vulnerable currencies they often print their bonds in the coinages of developed nations. Denoting bonds in first world currencies reduces bond purchaser concerns about value fluctuations. The most commonly traded currencies are American Dollars, British Pound Sterling, European Union Euros, or Japanese Yen. Printing in the currency of these nations also increases the circulation of the bonds from developing market nations and companies. The biggest bond markets trade these currencies, along with their investors.
Printing in foreign currencies does have a downside. The risk of default increases for nations or corporations which must convert currency. Instead of sovereigns being able to print their own money infinitely to pay bondholders, they must be able to raise a specific amount of foreign money during the bond’s term. This forces them to keep their fiscal management in check. They can’t acquire foreign currency easily if their own money is useless. Corporations, which cannot print money, must be able to raise foreign currency during the whole term. They are heavily exposed to exchange rate risk. If local currency loses value, they may end up paying substantial amounts of money to maintain the same amount of foreign interest payments.
You should seek a market with low correlation to your own domestic market. The correlation between emerging markets and the developed markets typically appears low, until tragedy occurs. If your domestic market makes up a vast amount of the emerging market’s business, you are not accomplishing much in the way of diversification. An economic crisis in your nation equals an economic crisis in the foreign country. Emerging markets that see their business primarily come from supplies or services to developed markets can be hit especially hard by a downturn in the developed world. A lack of demand will lead to the shutdown of corporate bond issuers and high unemployment, which reduces taxable income. The lack in taxable income can set an emerging market issuer up for default.
This says nothing of the geopolitical instability which can result in defaults. Revolt, famine, civil war, and international war will all bring a rise in corporate defaults, an increase in unemployment, and a decrease in taxable incomes for sovereign governments. This will also result in a flight to quality from the region. This occurs when investors rush to sell their bonds, equities, and properties to purchase investments in regions outside the affected zone. The result of these actions is a sudden spike in illiquidity. No one is buying, and everyone is selling.
Both of these scenarios result in sovereign emerging market issuers being hit by high unemployment and corporate shutdown. This leads to a lack of taxable income. In order to meet required payments for its bonds, the sovereign issuer may have to print more money to pay their lenders. This will often result in a rapid decrease in the value of their currency in exchange markets. The low value means they steadily have to pay more currency to reimburse each investment. Eventually, a lack of currency to pay foreign denominated issues occurs, followed by potential defaults.
To compensate you for their exposure to these risks emerging market issuers often pay substantially higher interest rates. It rises for the nation’s sensitivity to financial risks. For emerging market bonds to be a worthwhile investment, they must compensate for all potential problems. Their geopolitical sensitivity, economic sensitivity, illiquidity risk, volatility risk, and trading costs must be exceeded by their coupon rates. Returns for emerging market bonds are usually similar to high yield bonds, but some high risk emerging markets can rival equity market returns.
Due to their similarity during market calamities, their volatility, and their high return, you should consider them more like equity investments than bond investments. You should never substitute emerging market bonds for developed sovereign or corporate bonds in your portfolio. Emerging market bonds should never take more than 5% of your bond portfolio. It’s far safer to simply seek equity-like returns with equities than emerging market bonds.
Only invest in the emerging market with a bond fund focused purely on the target market. The manager of the bond fund must be well-informed and focused only on that market’s economic weaknesses and strengths. A distracted or unknowledgeable manager in emerging markets will function only slightly better than you. A great manager with high expenses is also useless, so be sure to shop around for lowered costs.
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