Research Affiliates: The Outlook For Emerging Market Bonds

July 24, 2014

EM local currency bonds appear to offer attractive real yields and improving credit quality.

Emerging market sovereign bonds that are issued in local currencies are supported by high real yields and improving credit quality. In addition, their risk-to-reward profile is enhanced by declining currency volatility and a positive long-term outlook for currency appreciation. This article explains why local currency emerging market bonds are attractive relative to historical valuation levels as well as current developed market opportunities.

If you are reading this article, you probably work in the financial services industry, and you have grown accustomed to friends, casual acquaintances, and even near-strangers expecting you to comment, with Crameresque authority, on penny-stock fliers, explain the latest day-to-day gyrations of the stock market, or reveal the secret code to the price path of gold futures. And, if you are like me, you might sidestep these questions and encourage your new friend to become a long-term investor in a diverse mix of index-based strategies.

Sometimes, however, you might receive a more interesting and open-ended investment question. My eyes always light up when I’m simply asked, “Where is your favorite place to invest today?” The answer, of course, depends heavily on current valuations and market conditions, but we always approach the question with an effort to understand the drivers of long-term risks and expected returns across many different asset classes.

So, you ask, where is my favorite place to invest? Right now, bonds issued by emerging market governments in their local currencies appear to offer far and away the most compelling investment opportunity. These bonds have four underpinnings for their exceptional risk-to-reward profile:

  • High real yields
  • Positive expected currency appreciation
  • Declining currency volatility
  • Strengthening credit quality

High Real Yields
First, note that emerging market sovereign bonds not only provide an attractive current yield relative to other market opportunities, but they are also relatively cheap compared to their historical average. The short- and medium-term “risk-free” government bond rates for the G-5 countries all currently reside in negative territory (see Figure 1). In developed markets, the right to a certain return of capital is actually costing anywhere from –1.5% to –0.5% per year in real purchasing power.1 On the other hand, real yields in many of the larger emerging market economies reside solidly in positive territory—returning anywhere from about a 1% premium over inflation in Mexico and Russia to more than 6% in the case of Brazil.

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