Introduction
In today’s complex global economy, investors are constantly seeking opportunities to enhance returns and diversify their portfolios . One asset class that continues to have bright prospects is emerging market bonds. These bonds, issued by governments and corporations in developing economies, offer unique opportunities for potential higher returns, and can be an effective component of a core-plus bond strategy.
What are Emerging Market Bonds?
Governments or corporations in developing countries issue emerging market bonds. Solid economic growth, increasing industrialization, a strengthening financial sector, and government policies enabling transition to a free-market economy characterize many of these countries. Said countries have favorable demographics, such as a relatively younger, well-educated workforce and a growing middle class. With increasing incomes, consumer spending is creating GDP stability. Combining favorable demographics with government policies in many countries that are favorable to investors, investment is attractive. Examples of emerging markets include Brazil, Chile, Mexico, China, India, Singapore, Malaysia, Thailand, Philippines, Poland, and South Africa, to name a few.
Unlike traditional fixed-income investments such as U.S. Treasury bonds or corporate bonds issued by established companies, emerging market bonds often offer higher interest rates to compensate for the perceived risks associated with investing in developing economies. These risks can include currency fluctuations, political instability, and credit risk.
The Core-Plus Bond Strategy Explained
The Hemispheres Investment Management (HIM) Core-Plus Bond Strategy is a diversified fixed-income investment approach that seeks to generate higher returns than a traditional fixed-income index. This strategy typically involves investing in a core portfolio of high-quality bonds, like those found in the Bloomberg Aggregate Index, and then allocating a portion of the portfolio to higher-yielding credit or non-investment-grade bonds. This would include emerging market (EM) bonds.
By incorporating EM bonds into a core-plus bond strategy, investors can potentially enhance returns while further diversifying their portfolios.
The Benefits of Diversification with Emerging Market Bonds
One of the benefits of investing in emerging market bonds is the potential for diversification. By adding these bonds to a portfolio, investors can reduce their exposure to domestic interest rate risk and economic fluctuations. Additionally, EM bonds often have low correlations with traditional fixed-income investments, which can help to smooth out returns over time.
Potential Returns from Emerging Market Bonds
Most global bond indices underrepresent EM bonds, resulting in fewer analysts following them compared to U.S. bonds. To attract investors, EM bonds often offer higher interest rates than traditional fixed-income investments. While emerging market bonds primarily offer income, they can also provide opportunities for capital appreciation. As EM economies grow and develop, the value of their bonds is expected to rise.
Understanding the Risks of Emerging Market Bonds
Investing in emerging market bonds is not without its risks. Some of the key risks include:
Currency Fluctuations
Changes in exchange rates can impact the returns on emerging market bonds. Hemispheres does not hedge against currency risk as it almost always buys U.S. denominated bonds. With the U.S. denominated bonds the currency risk is assumed by the issuer as it needs to repay its borrowings with U.S. Dollars. As with equity investing in different currencies, a strengthening U.S. dollar versus the foreign currency reduces the value of the security while a weakening U.S. dollar relative to the foreign currency increases the value of the security. As of September 18, 2024, the U.S. Federal Reserve began monetary easing by reducing interest rates by ½%. In isolation, lower U.S. interest rates weakens the dollar relative to foreign currency.
Political Instability
Political events, such as elections, structural changes in an economy and societal changes, can create uncertainty and volatility in emerging markets. Hemispheres closely monitors political and economic factors within the countries where it invests.
Geopolitical Risk
Geopolitical events such as wars, trade disputes, elections, and international agreements—often lead to short-term volatility in global markets. These events can impact investor sentiment, disrupt trade, and affect the economic policies of countries. For example, Brexit caused uncertainty in European markets, while ongoing U.S.-China trade tensions have affected global supply chains.
As a long-term investor, it’s important to look beyond short-term market noise and focus on underlying economic fundamentals. Temporary disruptions often present opportunity to earn excess return. Markets tend to recover from geopolitical shocks over time, so a disciplined approach to global investing, combined with proper diversification, will help you manage this type of risk. Hemispheres’ risk management procedures mitigate this risk through limitations placed on position size, as well as sector, country and regional limits.
Credit Risk
The same rating agencies that analyze credit in the U.S. analyze the credit of EM governments and corporations. Hemispheres performs in depth fundamental analysis to assess the creditworthiness of each company and country it invests in. HIM can manage most risks associated with global bond investing through due diligence, thorough research and an appropriate investment strategy.
Interest Rate Risk
Like all fixed-income securities, emerging market bonds are subject to interest rate risk. If interest rates rise, the value of existing bonds may decline. Please note that the opposite is true as well, declining interest rates increase the value of the bonds. If the investor holds the bond to maturity, they receive the full face value as repayment.
Conclusion
EM investing offers unparalleled opportunities to diversify your portfolio, enhance returns, and gain exposure to markets with impressive fundamental prospects. However, it also comes with its own set of risks and challenges. Working with knowledgeable and seasoned professionals, such as Hemispheres Investment Management, you can harness the benefits of global bond investing. The principals at Hemispheres Investment Management have successfully managed Global Portfolios for over 35 years.
All forms of investing require periodic review and adjustments. Whether you’re looking to capitalize on opportunities in emerging markets or hedge against risks in the U.S, EM investments can play an important role in building a resilient and prosperous portfolio. When combined appropriately with the stable, developed market investments that make up the core element of the portfolio, Hemispheres can successfully manage your overall credit risk.
Please contact Hemispheres Investment Management for a free consultation. We offer customized guidance and strategies that can help you or your business meet your financial objectives. Book a Meeting
