Recently I wrote about ETF’s for international bond funds that are denominated in local (non US Dollar) currencies. The NYT in their Sunday edition had a mutual fund report (they still segregate mutual funds from ETF’s, even though they are generally substitutes for one another) that discussed a similar tactic called “Emerging-Market Bonds Quench a Yield Thirst“. This article is focused on emerging markets (like Brazil and China and the Asian countries) rather than the developed markets that those ETF’s target.
The article approaches foreign bonds as a way to achieve a higher yield (interest income) since US interest rates are minuscule.
With the measly yields now offered on presumably safer bonds, like United States Treasuries, savers are seeking more appealing sources of income. And in the first quarter this year, the average emerging-bond fund tracked by Morningstar returned 7 percent, versus 0.3 percent for the Barclays Capital US Aggregate Bond Index.
The article gets more sophisticated but this is a “classic” case of confusing risk and return. The return on emerging market debt SHOULD be substantially higher than for less-risky debt, assuming that US debt is actually less risky.
The relative risk of emerging markets compared with developed markets has changed… The average debt level of emerging market countries like Brazil and China is far lower than that of developed ones like the United States and Japan… emerging economies have continued to surge even as much of the developed world keeps struggling with the aftermath of the 2008 financial crisis.
That’s true. If you ignore the complexities of legal systems and whether or not a country like Brazil or China would default if it was in their best interests to do so, by statistics alone they are superior to the developed world. Having a modern legal system and being tied to the West didn’t save Greek debt holders from having to take a 75% loss on principal, after all.
The article goes on to describe two key differences – bonds issued in US dollars (“dollar bonds”) and those that invest in bonds denominated in local currencies. In the previous article on foreign ETF’s I covered Germany, Canada and Australia – those countries would not offer bonds denominated in anything but their local currencies (Euro for now, Canadian dollar, and Australian dollar) but for emerging countries often the debt is denominated in some other currency which makes it more palatable to investors, particularly non-local investors.
If you denominate an emerging market bond in US dollars, then that has the same effect as “hedging” your bond portfolio against fluctuation in the local currency against the dollar, which is a frequent practice for many mutual funds because investors wanted purely the higher yield (and theoretical increase in risk of principal loss that come with this) and didn’t want to also add in the “currency risk” of fluctuations against the US dollar.
Whether the mutual funds invest in “dollar bonds” or bonds denominated in local currency will impact the potential returns of the fund as well as the riskiness of the assets in the fund (likelihood of default). Per the article many of the funds operate a “mix” of these strategies, which may mitigate some risk (dollar bonds may be issued by more solvent issuers and also don’t have currency risk) but likely leaves some yield “on the table” from local issuers willing to pay a higher rate in local currency as well as the potential gain or loss on fluctuations from the local currency vs. the US dollar.
In the US, corporations mostly go to the public corporate bond market for funding, whereas in emerging countries companies often go to local banks (and Europe is somewhere in the middle). Since so many companies in the US rely on markets for debt funding, the overall market is (relatively) liquid and large in size, and as a result there are many metrics to track and there is a long history of data to review. In developing countries, the corporate markets aren’t very deep, and those that do issue debt rather than going to banks often issue it in “dollar” bonds instead of local currencies. Per the article:
Local-currency corporates exist in Brazil, but the market isn’t very deep… in a less mature market, he might stick with dollar issues.
Compared to the total universe of mutual funds and ETF’s, the portion that is tied to
- emerging market debt
- has bonds denominated in local currencies and / or “dollar” bonds
- has a liquid enough market to make sense
- Shy away from the pitifully low yields offered from US entities
- Realize that the credit quality of the US (recently downgraded) and many states (such as Illinois, which is in dire financial straits) is not what it used to be
- Realize that the US dollar has been in a long term decline over many decades against many major currencies and by being substantially invested in US dollar denominated assets they are in effect losing return when compared against foreign based assets (even though it doesn’t show up directly in the US dollar based financial statements)