Rethinking risk in fixed income
Although the run-up in emerging-markets debt may seem a little long in the tooth, a good case can still be made for purchasing these bonds.
Although the run-up in emerging-markets debt may seem a little long in the tooth, a good case can still be made for purchasing these bonds.
By most measures, the average 6% yield on the broad category of emerging-markets government bonds looks like a fair trade-off for their perceived risk. By comparison, U.S. Treasuries are yielding half as much.
But for those who spend much of their waking hours crunching data in this area, emerging-markets debt is looking more attractive and less risky with every passing day.
Case in point: In a recent analysis of government-issued debt from both developed and emerging countries, Research Affiliates LLC found that developed markets — including the United States — actually pose more risk to investors. Research Affiliates gauges the ability of a country or market to service its foreign debt by analyzing four factors of economic production: gross domestic product, labor, resources based on landmass, and energy consumption for the production of goods and services.
As a group, the developed markets account for $16.7 trillion in outstanding sovereign-bond debt, 89.5% of the world’s total debt. Based on the four factors of economic production, the research showed, the developed markets aren’t well-poised to service that debt with only 62.4% of the world’s GDP, 19% of the labor force, 35.3% of resources and 54% of energy consumption for production.
The United States stacks up slightly better than developed markets as a whole, but it is still well behind the emerging markets. With $4.3 trillion in outstanding sovereign debt, the United States represents 23% of the world’s debt but just 5.9% of both global labor and resources.
The U.S. GDP and energy factors are neutral at about 23% each, equal the global market weight of its debt.
Now consider the $1.9 trillion in outstanding sovereign debt from all emerging nations, which represents 10.5% of global debt. In terms of an ability to service that debt, the emerging markets represent 37.6% of global GDP, 81% of the labor force, 65% of resources and 46% of energy consumption.
“There is a widespread belief that emerging-markets debt is riskier than developed-market debt, and you have the yield premium as proof of that, but based purely on the actual ability to pay that debt, it ought to be the other way around,” said Rob Arnott, the chairman and founder of Research Affiliates.
Another factor that tilts in favor of the emerging markets is that the debt used in the Research Affiliates calculations doesn’t even factor in the United States’ off-balance-sheet debt in the form of state and local debt, and the $46 trillion in funded and unfunded obligations to Social Security and Medicare.
“The only reason yields on 10-year Treasuries are at 2% right now is because of a flight to quality, but it’s a false sense of safety,” Mr. Arnott said.
Many observers have recognized the upside-down perception of sovereign-debt risk, relative to a country’s ability to service the debt.
“It used to be if a country had a developed-market label, it got a free pass [from investors] on its lax policy strategies, and the emerging markets would get punished if there was even a whiff of trouble,” said Art Steinmetz, chief investment officer in charge of fixed income at OppenheimerFunds Inc.
“The monikers are starting to not matter, because the emerging economies really are the engines of the world right now, and over the past year, the problems facing the developed markets have been laid wide open,” said Mr. Steinmetz, who manages the $12 billion Oppenheimer International Bond Fund (OIBAX) and the $8 billion Oppenheimer Global Strategic Income Fund (OPSIX).
As long as the overall market continues to view emerging-markets debt as the riskier alternative, investors can enjoy the benefits of higher yields and lower risk.
Ways to tap into emerging- markets debt through exchange-traded funds include Market Vectors Emerging Markets (EMLC), which is local-currency-denominated, or PowerShares Emerging Markets Sovereign Debt (PCY), which is U.S. dollar-denominated and has no local-currency risk.
If mutual funds are your thing, there is the Templeton Global Bond Fund (TPINX), which invests mainly in emerging-markets debt.
Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].
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