Investment Strategy

Emerging market bonds say “buy me”

Risk, like beauty, is often in the eye of the beholder. For example, most folks consider U.S. Treasury bonds to be a low-risk asset. But in the eyes of some beholders, like me, today’s low-yielding Treasurys are a high-risk asset.

Because most Treasury securities now yield close to nothing, they offer what a good friend of mine calls “return-free risk.” If things go well with this investment, you’ll make a tiny bit of money. If things go slightly less well, you’ll lose a lot of money.

That’s a high-risk proposition.

Emerging market bonds are also high-risk. But at least they offer the promise of a high reward to go along with that risk. Not only do they pay high interest rates, but they also provide an opportunity to profit from a falling dollar.

So it’s easy to make the case that a diversified portfolio of emerging market bonds has become a much more alluring risk than a portfolio of Treasurys. Consequently, it’s easy to make the case that investors should be selling Treasurys and buying emerging market bonds.

Let’s take a look at the trends that have created this particular investment opportunity.

Ever since the 2008 crisis, the Federal Reserve has been trying to stimulate economic growth by manipulating interest rates lower.

Ever since the 2008 crisis, the Federal Reserve has been trying to stimulate economic growth by manipulating interest rates lower. To conduct this manipulation, the Fed has purchased trillions of dollars’ worth of Treasurys in the open market – a process that became known as quantitative easing.

The Fed’s bond-buying campaign pushed interest rates even lower.

(Remember, price and yield move in opposite directions. So when bond prices rise, yields fall.)

As interest rates fell, ordinary investors rushed in to buy Treasurys… before rates fell even lower. This multiyear buying frenzy pushed down rates on 10-year Treasurys from nearly 4.0% at the end of 2009 to a recent low of 1.45%.

Thanks to this big bull market, long-dated Treasurys have been producing huge equity-like returns during the last several years. For perspective, an investor who purchased the iShares 20+ Year Treasury Bond ETF (NYSE: TLT) at the end of 2009 would be sitting on a total return of 91% right now, which is not far behind the 123% return the S&P 500 Index delivered over the same time frame.

But interestingly, emerging market bonds have not been rallying alongside Treasurys; they’ve been doing the opposite.

They’ve been falling… a lot. The chart below tells the tale.

The iShares ETF share price is up nearly 50% during the last five years, while the price of the VanEck Vectors J.P. Morgan Emerging Market Local Currency Bond ETF (NYSE: EMLC) is down more than 30%.

The soaring U.S. dollar caused most of the damage to the value of the VanEck Vectors ETF. That’s because this ETF holds emerging market bonds that are denominated in the local currencies of each issuing country. So when the U.S. dollar goes up in value, these various foreign currencies go down in value. Therefore, the U.S. dollar value of the bonds in the VanEck Vectors ETF portfolio goes down.

You can see that inverse relationship very clearly in the chart below.

You can also see that the dollar has been weakening somewhat during the last few months, which has boosted the performance of the VanEck Vectors ETF. The ETF is up 14% year to date. If the dollar’s recent weakening trend continues, the VanEck Vectors ETF could continue to deliver very large gains.

But the likelihood of dollar weakness is just one part of the VanEck Vectors ETF’s investment appeal. The other part is the high rate of interest its bond portfolio pays.

This ETF holds about $2 billion worth of emerging market government debt from countries like Poland, Mexico, Brazil and Indonesia. Thanks to these high-yielding securities, the VanEck Vectors ETF pays an annual dividend yield of 5.14%.

So let’s put that yield in our back pocket for a moment and consider a couple of possible scenarios:

  1. If, over the next 12 months, the U.S. dollar slumped to its year-end 2014 level, the VanEck Vectors ETF would deliver a total return of roughly 20%.
  2. If, over the next 24 months, the U.S. slumped to its year-end 2013 level, the VanEck Vectors ETF would deliver a total return of roughly 44%.

The dollar may not continue weakening, of course. But then again, nothing is risk-free… not even U.S. Treasurys. To put that risk in perspective, let’s consider two more plausible scenarios:

  1. If, over the next 12 months, the yield on the U.S. 10-year Treasury rose ever so slightly from its current yield of 1.59% to its year-end 2014 yield of 2.17%, the price of the 10-year would fall about 4%.
  2. If, over the next 24 months, the yield on the U.S. 10-year Treasury rose to its year-end 2013 level of 3.02%, the price of the 10-year would fall about 10%.

Those results might not be disastrous, but they aren’t particularly appealing either. After all, a loss of 10% would wipe out six years of interest payments from a 10-year Treasury yielding 1.59%.

My advice? Sell “low risk” Treasury ETFs like the iShares Bond ETF; buy “high risk” emerging market bond ETFs like the VanEck Vectors ETF.

Cheers,

Eric J. Fry
For The Non-Dollar Report

 

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