As readers will know, I’m generally bullish on emerging market stocks. They provide exposure to the more rapid growth in those markets, and I believe them to be undervalued today.
Thus, income investors looking for bond opportunities may feel that emerging market bonds are also an attractive alternative. Indeed, they offer better yield than good quality government or corporate debt and at first sight appear to be an attractive investment.
For example, the yield in the iShares JPMorgan USD Emerging Market Bond ETF (EMB) is 4.8%, which won’t make you rich but certainly beats the 1.9% available on 10-year Treasuries.
Emerging market debt also represents diversification from high-yield U.S. corporate debt. The trouble at Valeant Pharmaceuticals International Inc. (VRX) demonstrates how vulnerable that market is to scammers, fast-buck artists, and leveraged business plans that blow up as soon as a recession looms.
Unfortunately, emerging market debt just isn’t as good a deal as emerging market stocks.
By definition, emerging market stocks originate in the private sector, and the most attractive stocks come from countries with vibrant stock markets and rapidly growing, free-market economies. Meanwhile, a large amount of debt is a red flag in the stock universe.
On the other hand, the great majority of emerging market bonds are issued by governments, because emerging market corporations are mostly too small to issue debt with an adequate liquidity.
Then, because of the way indexing works, governments with more debt are given a greater weighting in the emerging market debt index. In general, companies with free-market economies, low debt, and vibrant stock markets are underrepresented.
Thus, the top six countries in EMB, with weightings ranging from 6.8% to 4.1%, are Mexico, Russia, Indonesia, Turkey, the Philippines, and Brazil. That’s not a collection of well-run countries, except for the Philippines.
Mexico has a remarkably slow growth rate given its emerging markets middle-income status. Meanwhile, Russia is a corrupt and dictatorial world-destabilizing force. If you could buy shares in the Russian military’s adventures I might be tempted, but its civilian economy is another story.
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Indonesia is a huge country and is only somewhat badly run, but you’ll find very few Indonesian counters in most global stock portfolios.
Turkey is hugely over-indebted and looking increasingly unstable, with budget deficits and balance of payments deficits that don’t bode well for the future.
Finally, Brazil is entering an ever-deepening recession, has far too large a government, and is suffering from an exploding budget deficit and a political crisis.
In short, the constituents of EMB and of the standard emerging markets bond index – the JP Morgan EMBI+ – show all the unpleasant features that put off many investors from emerging markets.
Add to that the fact that you’re financing the most corrupt and least-productive sectors of these countries’ economies, and you can see how problematic these investments really are.
For comparison’s sake, the equivalent equity portfolio of the iShares MSCI Emerging Markets ETF (EEM) has China at 23.9%, South Korea at 15.4%, Taiwan at 12.6%, and India at 8.2%, all countries you’d generally want to invest in. It’s not until you get to South Africa at 6.2% that you find a country you’d probably want to avoid.
Now, you might think you’d do better specializing in emerging market corporate bonds.
The iShares Emerging Market Corporate Bond ETF (CEMB) is a tiny $23 million ETF that invests in emerging market corporate bonds and aims to match the Morningstar Emerging Markets Corporate Bond Index. It has an expense ratio of 0.53% and a yield of 4.7%.
The problem here is that bonds aren’t stocks. Your largest holdings are still Brazil, Mexico, and the Russian Federation, so you haven’t reduced risk that much from the government bond index.
In addition, the corporations in which CEMB invests tend to be state-controlled dinosaurs, although after Pemex and Petrobras, the third-largest is Korea’s Eximbank, which, like the fourth-largest holding, Chile’s Codelco, is at least from a creditworthy country.
Still, you’ve only modestly improved your risk profile by choosing this option.
Bottom line: For structural reasons, emerging market bonds aren’t as good an investment as emerging market stocks, and they should form at most a modest part of your portfolio.