Emerging bonds are a good bet this year

Kathleen Brooks
LOW interest rates have been one of the less attractive aspects of holding developed market debt in recent years. But after recent events in Europe you can now add sovereign risk to that list. Investors who want a safer fixed income alternative should look at bond funds in emerging markets.

It’s not that long ago that investors would have balked at the idea of buying debt from the developing world. Russia defaulted in 1998 and the Asian debt crisis rocked markets the year before. However, the developing world has since taken steps to get their financial houses in order and came into the 2007 financial crisis in good shape relative to G7 nations.

Warren Hyland, fund manager at Schroders, points out that, on average, the debt-to-GDP ratio of emerging market nations was approximately 35 per cent in 2007, compared with 80 per cent for developed countries. Other attractive features of emerging bonds include less sovereign risk due to healthier fiscal balances and a strong growth outlook.

High inflation used to be a major problem for emerging markets, but, says Hyland, that is no longer the case. Food prices, which make up between 30 and 50 per cent of emerging nations’ inflation baskets, have remained fairly moderate this year. Also private sector credit growth (see chart), a lead indicator of inflation, remains fairly subdued for emerging nations.

Emerging market debt comes in two forms: external debt, typically priced in US dollars, and local currency debt. Kevin Daly, portfolio manager at Aberdeen Asset Management, favours local currency bonds due to the higher yields they offer. He also likes their exposure to currency movements in the developed world, which Daly believes could experience much upside in the medium term. He is particularly attracted to Indonesian bonds, which he thinks offer good value.

But how have emerging bond funds actually performed? The usual benchmark for these types of funds is the JP Morgan Emerging Market Bond Index, which has returned 3.74 per cent since the start of the year. However, individual funds have performed even more strongly, according to the independent fund research service Morningstar. The Aberdeen Emerging Market Bond Fund has returned more than 12 per cent since the start of the year and Schroders ISF Emerging Market Debt Absolute Return Fund has posted returns of 7.5 per cent. And historical performance is also good. The Julius Baer Local Emerging Bond Fund, celebrating its 10-year anniversary, has delivered an average annual performance of 10 per cent.