In a search for higher yield, many investors have turned to more
exotic asset classes such as Emerging Market ((EM)) bonds. EM bonds
were on a tear since the bear market ended in 2009 until they
stumbled last year. Last May, EM bonds sold-off after the Fed began
to discuss plans for tapering, which sparked fears that less
capital would be flowing into emerging markets. The performance of
EM bonds last year was definitely not the type of results you would
want for your retirement account. However, I must confess that I
like to maintain a small investment in this asset class because of
attractive yields, potential capital gains, and diversification. If
you decide to invest in this type of bond, the question is: what
are the "best" funds to purchase?
There are many ways to define "best." Some investors may use
total return as a metric but as a retiree, risk is as important to
me as return. Therefore, I define "best" as the asset that provides
the most reward for a given level of risk and I measure risk by the
volatility. Please note that I am not advocating that this is the
way everyone should define "best"; I am just saying that this is
the definition that works for me.
Emerging markets refer to securities domiciled in a country that
is considered to be emerging from an under-developed economy to a
more mainstream environment. The countries considered to be
emerging are mostly in Africa, Eastern Europe, the Middle East,
Latin America, and some Asian countries excluding Japan. Many of
these economies depend on either exporting commodities or providing
services to the more developed world. There are several subclasses
of EM bonds. For example, EM bonds may trade in either the currency
associated with their country or trade in U.S. dollars. In
addition, EM bonds may be corporate bonds or Government treasuries
(which are usually referred to as Sovereign debt).
Some of the reasons for investing in emerging market debt
- EM bonds offer higher yields than comparable bonds from
- As the credit worthiness of an emerging economy improves, the
rating of the bonds may improve leading to capital gains.
- EM bonds rise and fall due to local conditions, which may not
be in sync with the U.S. market, thus offering
- If the EM bond is denominated in local currency, there is a
potential for additional appreciation due to currency
fluctuations. Of course, depreciation is also a possibility.
Since many EM bonds are thinly traded and are available only on
local exchanges, it is difficult for individual investors to
purchase these bonds. The easiest way to invest in this asset class
is to buy funds. Exchange Traded Funds (ETFs) are the most popular
vehicle with some ETFs trading over 700,000 shares per day.
However, Closed End Funds (CEFs) are an alternative choice. The
closed nature of these CEFs makes it easier for the manager to
invest and hold limited liquidity assets without having to worry
about cash inflows and outflows. However, the downside of CEFs is
that the price is based on market action, which can wreak havoc
when the asset falls from favor. This was demonstrated with a
vengeance in the second quarter of 2013 when talk of tapering
caused the average share price of these CEFs to drop 11%.
This article will compare the risks and rewards of EM bond
funds, both CEFs and ETFs, versus more conventional US treasuries
and high yield corporate bonds. I will use a 5-year time frame and
require that the selected funds trade at least 50,000 shares per
day. Based on these criteria, I selected the following CEFs for my
MS Emerging Markets Domestic (
This CEF invests in emerging market domestic debt and sells for a
discount of 6.8%, which is higher than its 52-week average
discount of 11.9%. This is the only leveraged fund that invests
exclusively in local currency debt. The fund has 42 securities,
almost all in sovereign debt. Even though the bonds are from
emerging markets, about 85% are actually investment grade (BBB or
higher). The fund invests in a wide range of countries including
Brazil (17%), Turkey (13%). Russia (12%), South Africa (11%) and
Mexico (11%). In terms of bear market performance, the price of
this fund dropped 29% in 2008. It also lost 13% last year. The
fund utilizes 25% leverage and has an expense ratio of 2.5%. The
distribution rate is usually about 7.6% but last year the fund
paid out an additional special dividend of an additional 4%.
MS Emerging Market Debt (
This CEF sells for a discount of 13.3%, which is lower than its
average discount of 11.5%. The fund has 104 holdings, with about
80% in sovereign debt and 15% in corporate bonds. Virtually all
the bonds are denominated in U.S. dollars. Geographically, the
holdings are distributed among a large number of countries
including Mexico (14%), Russia (13%), Indonesia (9%), Venezuela
(7%), and Turkey (7%). About 73% of the bonds are investment
grade. In 2008, the price of this fund fell 18% and in 2013, the
price dropped 13%. The fund is only 65% correlated with its
sister fund, EDD. MDD uses 16% leverage and has an expense ratio
of 1.2%. The distribution is about 5.7% but a special
distribution of 2.8% was paid last year.
Western Asset Emerging Market Debt (
This CEF sells at a discount of 11.1%, which is lower than its
average discount of 8.2%. It has 180 holdings with about 50% in
sovereign debt and 42% in corporate bonds. The assets are
distributed among several countries including Mexico (10%),
Turkey (9%), Venezuela (9%), Brazil (7%), and Cayman Islands
(6%). In 2008, the price of this fund fell 27% and in 2013, the
price dropped almost 17%. The fund uses only 8% leverage and has
an expense ratio of 1.2%. The distribution is 8.4%, consisting
primarily of income and long-term gains.
Western Asset Emerging Market Income (
This CEF sells for a discount of 12.2%, which is significantly
below its average discount of 8.8%. The fund has 181 holdings
with 55% in sovereign debt and 43% in corporate bonds. About 75%
of the holdings are investment quality. Note that this fund has
43% of the holdings in the U.S.A. and only about 57% in emerging
markets. The top five emerging markets represented in the fund
are Russia (8% of total assets), Venezuela (8%), Turkey (7%), and
Mexico (6%). In 2008, the price of this fund dropped 28% and in
2013, the price went down 17%. This fund is about 76% correlated
with its sister fund, ESD. EMD utilizes 8% leverage and has an
expense ratio of 1.2%. The distribution is 8.4%, consisting
primarily of income plus realized long term and short-term
Global High Income Fund (
This CEF sells for a discount of 13.4%, which is lower than its
average discount of 10.7%. The fund has 254 holdings, with 67% in
sovereign debt and 19% in corporate bonds. All the holdings are
denominated in U.S. dollars. The holdings are distributed among a
large number of countries including Brazil (12%), Turkey (8%),
Indonesia (7%), Russia (7%), and Venezuela (6%). About 40% of the
holdings are investment grade, 20% below investment grade, and
the rest unrated. In 2008, the price of this fund fell 32% and in
2013, the fund lost 17% in price. This fund does not use leverage
and has an expense ratio of 1.5%. The distribution is a high 8%,
consisting primarily of income and gains but some of the
distribution recently appears to be destructive return of
Templeton Emerging Markets Income (TEI).
This CEF sells at a discount of 2.7%, which is slightly below its
average discount of 1.8%. This fund has 115 holdings with 56%
invested in sovereign debt and 34% in corporate bonds. The
securities are distributed across many countries including Brazil
(9%), Kazakhstan (8%), Mexico (8%), Ghana (6%), and Ukraine (6%).
About 83% of the holdings are denominated in U.S. dollars. In
2008, the price of this fund dropped 20% and in 2013, the price
fell by 13%. The fund does not utilize leverage and the expense
ratio is 1.1%. The distribution is 7.2%, consisting of income. In
2013, the fund also has a special distribution of 3%, comprised
of income and long-term gains.
In addition to CEFs, there are a number of ETFs that specialize
in emerging market debt but only two have a 5-year history and
trade at least 50,000 shares per day. The ETFs that I used for my
iShares J.P. Morgan USD Emerging Market Bond
This ETF is a passive fund that tracks an index made up of U.S.
dollar denominated emerging market bonds. The country allocations
are rebalanced monthly based on the amount of outstanding debt.
The fund has 247 holdings, all in sovereign debt and spread
across a large range of countries including Russia (6%), Brazil
(6%), Philippines (6%), Turkey (6%), and Mexico (6%). About 50%
of the bonds are investment grade. The price of this fund lost a
relatively low 12% in 2008. It should be noted that in 2008, the
price deviated significantly from the Net Asset Value ((NAV)),
which fell less than 2%. This is very unusual for ETFs and
illustrates how badly the financial markets were dislocated in
2008. The fund lost about 7% in 2013 (in both price and NAV). The
fund has an expense ratio of 0.60% and yields 4.7%.
PowerShares Emerging Markets Sovereign Debt
This ETF tracks an equal weight index of emerging market
sovereign debt from 22 countries. The fund has 66 holdings with
about 62% being investment grade. In 2008, the price dropped 19%
(NAV dropped 15%) and in 2013, both the NAV and price fell about
10%. The fund has an expense ratio of 0.50% and yields 4.5%. Over
a 5-year period, PCY was 69% correlated with EMB.
For reference, I compared the performance of the EM bonds to the
following U.S. bond ETFs:
iShares Barclay 7-10 Year Treasury Bond (IEF).
This ETF consists of intermediate term treasuries. It racked up
impressive gains of over 17% in 2008 (followed by a loss of over
6% in 2009 and again in 2013). This fund has a very low expense
ratio of 0.15% and yields 1.8%.
iShares iBoxx $ High Yield Corporate Bonds (HYG)
. This ETF invests in below investment grade ("junk") bonds and
was devastated in 2008 with the price falling over 17%. The NAV
fell even more (23%) but quickly recovered in 2009. HYG generated
a positive return of about 6% in 2013. The fund has an expense
ratio of 0.5% and yields 6%.
To determine which of the emerging market investments were
"best," I plotted the annualized rate of return in excess of the
risk free rate (called Excess Mu in the charts) versus the
volatility for the past 5 years. The
was used to generate the plot shown in Figure 1.
(click to enlarge)
Figure 1. Risk vs. reward over past 5 years.
As is evident from the figure, there was a relatively large
range of returns and volatilities. For example, TEI had a high rate
of return but also had a high volatility. Was the increased return
worth the increased volatility? To answer this question, I
calculated the Sharpe Ratio.
The Sharpe Ratio is a metric, developed by Nobel laureate
William Sharpe that measures risk-adjusted performance. It is
calculated as the ratio of the excess return over the volatility.
This reward-to-risk ratio (assuming that risk is measured by
volatility) is a good way to compare peers to assess if higher
returns are due to superior investment performance or from taking
additional risk. In Figure 1, I plotted a red line that represents
the Sharpe Ratio associated with EMB. If an asset is above the
line, it has a higher Sharpe Ratio than EMB. Conversely, if an
asset is below the line, the reward-to-risk is worse than EMB.
Some interesting observations are apparent from Figure 1. First,
the CEFs were substantially more volatile than the ETFs. Emerging
market CEFs were even more volatile than HGY, which represents
United States high yield bonds.
On the other hand, the emerging markets ETFs (EMB and PCY) were
not very volatile, with volatilities just a little more than
intermediate term treasury bonds. This leads to the recommendation
that if an emerging market bond investor is not risk tolerant; he
should stick with the ETFs and not venture into CEFs.
In absolute terms, all the CEFs except GHI had higher returns
than their ETF counterparts. This is not that surprising since the
CEFs are actively managed and many use leverage. However, as shown
in the figure, the increased returns were not sufficient to offset
the increased volatility and all the CEFs had risk-adjusted
performance worse than EMB or PCY. If you focus only on the CEFs,
then EMD had the best risk-adjusted performance, followed by ESD.
The risk-adjusted performance of MSD was about the same as TEI. GHI
lagged badly in terms of both absolute return and risk-adjusted
Next I wanted to see if the diversification promised by these
emerging market bonds lived up to expectation. To be "diversified,"
you want to choose assets such that when some assets are down,
others are up. In mathematical terms, you want to select assets
that are uncorrelated (or at least not highly correlated) with each
other. I calculated the pair-wise correlations associated with the
selected funds. The results are provided in the 5-year correlation
matrix shown in Figure 2. As is evident from the matrix, these CEFs
provided relatively good diversification. The CEFs were negatively
correlated with intermediate treasuries and (somewhat surprisingly)
the CEFs were only 30% to 45% correlated with EMB and PCY. The CEFs
were only moderately correlated among themselves, with correlations
in the 50% to 70% range. The largest correlation was between EMB
and PCY at 70%. So my conclusion was that these CEFs lived up to
expectation and provided a reasonable amount of portfolio
(click to enlarge)
Figure 2. Correlation over past 5 years.
As we have previously discussed, emerging market bonds were in a
strong bull market until last year. So I decide to see which of
these funds performed best during the 4-year bull market period
from March 2009 to March 2013. The results are shown in Figure
(click to enlarge)
Figure 3. Risk versus reward: bull market (2009 to
As expected, all the funds had excellent performance over this
bull market period. Interestingly, the relative performance of the
funds was almost exactly the same as the 5-year results. During the
bull market, the CEFs continued to generate high returns but this
was again coupled with high volatility. However, during the bull
market some of the CEFs had risk-adjusted performance almost as
good as EMB. This was especially true for EMD and ESD, with MSD not
far behind. GHI continued to lag the other funds.
If you are a conservative investor who wants to diversify into
emerging market bonds, the ETFs, either EMB or PCY, are your best
bets. These ETFs offer better returns than IEF, with about the same
volatility. The risk-adjusted performance of the emerging market
ETFs is about the same as that received from high yield corporate
The emerging market CEFs are not for the faint hearted but if
you can stand the volatility, they offer the potential for high
returns. If you want to invest in CEFs, I would go with EMD, ESD,
or MSD. However, please be aware that these CEFs can drop
substantially if the emerging market bonds enter another bear
I am long EMB. I wrote this article myself, and it expresses my own
opinions. I am not receiving compensation for it. I have no
business relationship with any company whose stock is mentioned in
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