Emerging market corporate bonds: a paradise, if actively managed
For some bond investors the words “emerging-market corporate bonds” conjure up thoughts of hair raising, stomach turning, wild rollercoaster rides. But a closer look at this misunderstood asset class reveals a different reality.
As yields have continued to slide since the end of the financial crisis of 2008, the fixed-income markets are facing a new epoch. It’s all turned upside down and a bit Alice in Wonderland. For example, volatility has encroached on the safest and most stable area of fixed income: developed-market government bonds.
So, it’s not just yields that bond investors are crying after, it’s also stability. What we are seeing is that volatility in traditional safe-haven bonds is rocketing. Here, emerging-market corporate bonds can offer a solution because they have, on a risk-adjusted basis, delivered consistent returns with less volatility than many think.
When we look at the data, that volatile rollercoaster ride starts to look more like a pleasant tram journey. Chart 1 below shows the daily volatility and maximum drawdowns for various asset classes. What is interesting, and should be worrying for investors, is that for developed-market government bonds (Euro Gov and US T Index) daily volatility and maximum drawdowns are greater than the emerging-market corporate bond index (JPM CEMBI, far left).
So let’s take a closer look at the drawdowns.
If we look further back in time, from 2007 onwards, we can find some significant drawdowns compared to developed-market investment-grade and government bonds, for example. However, drawdowns are part of investing and the key question is not the size of the drawdown but, in our opinion, the time to recovery.
Sudden market implosions are big news and ideal fuel for headlines, but what those headlines fail to do is tell you the comeback story that often follows.
Chart 2 below shows how emerging-market corporate bonds can plunge when things go wrong. For example, the worst drawdown for emerging-market corporate bonds since 2007 was over 25%, compared to “just” around 8% for US Treasuries. It should be noted though that dramatic drawdowns are rare, barring 2008, losses on the emerging-market corporate index have not surpassed 10%.
When it comes to recovery times, it was emerging-market corporate bond investors who had the last laugh as chart 3 below shows – if they held firm, their portfolio recovered faster than US Treasuries.
So, while US Treasuries may not test an investor’s nerves in the same way as emerging-market corporate bonds when there is a significant drawdown, emerging-market corporate bonds do offer a faster recovery.
Now that we’ve seen that the volatility fears are overblown, the key question investors want answered is: am I being compensated for the risk I take? For this, a commonly used indicator of risk-adjusted returns is the Sharpe ratio. The higher the Sharpe ratio, the more excess returns investors receive for the risk they take. As chart 4 shows, emerging-market corporate bonds offer attractive risk-adjusted returns compared to other asset classes. What you should also note is that in recent years, emerging-market corporate bonds show an increasing Sharpe ratio, unlike other fixed-income sectors.
So, now that yields in many fixed-income segments are submerged in negative territory and volatility is soaring, it's a good time to reassess how emerging-market corporate bonds behave and what they can offer. Rather than considering emerging-market corporates as high-risk/high-return assets, they should be viewed as an essential part of a diversified, performance-seeking bond portfolio.