As the world pulled back from the edge of the financial panic early this year, investors began moving into speculative debt, including bonds from emerging markets such as China, India, Brazil and more. Since then, this sector of the fixed income market has soared. Here is my question: Is the big move in bonds from emerging markets a sign that the higher rates of economic growth in emerging countries are finally getting the notice they deserve? Or, is it just another case of a market that has gone up too far and too fast?
In Part One of this two-part post, we examine the bullish case for emerging market bonds. In Part Two, we will examine the theory that emerging market bonds are — or may soon be — entering bubble territory.
Part One: The bullish case for emerging market bonds
An article from the Economist by financial columnist Buttonwood tends to the bullish position on emerging market debt although the use of the term ‘bubble’ lends an element of backpedaling to the piece [emphasis added]:
A developing bull market (The Economist, Nov. 26, 2009, Buttonwood)
…The bullish argument for emerging-market bonds is based not just on the state of government finances but on the outlook for foreign-exchange markets. The American government may talk about the desirability of a strong dollar but it seems to have no intention of doing anything about it…
You heard this point before on these pages (or pixels I should say) that our government talks avidly of a strong dollar, but then it pursues weak dollar policies. For more on the topic of the weak U.S. dollar see, How far has the dollar fallen? And why?
Buttonwood of the Economist continues with the bullish case for emerging market bonds:
…some emerging countries may find their currencies appreciating, no matter what policy they follow.
What if they give in to Western political pressure and allow a modest currency rise? Then investors will speculate that further appreciation is likely. Alternatively countries may choose to intervene in the foreign-exchange markets to prevent their currencies from rising. But the effect of such a policy will be to increase their foreign-exchange reserves (as they sell their own currencies and buy dollars or euros). That will make the country's fundamentals look even more attractive and encourage even greater investment.
In addition, importing loose monetary policy from America (as countries try to peg their currencies to the dollar) may create asset bubbles within emerging markets. Those will attract speculative inflows. And if developing countries try to restrict those bubbles by raising interest rates, that will only make their currencies even more attractive as yield-hungry investors pile in.
The trend is already well under way. EPFR Global, an information group, says that emerging-market-bond funds attracted the largest monthly inflow in October since it began collecting the data in 1995.
Morningstar (see here for data) reported that Emerging Market Bond Funds took in $952 million in October. However, at roughly $18 billion in assets, this catagory is still very small. By way of contrast, Emerging Market Stock Funds have roughly $128 billion in assets.
Buttonwood continues:
Spreads (the excess yield over Treasury bonds), as measured by JPMorgan's index of emerging-market bonds, have fallen from more than five percentage points in October 2008 to less than four percentage points now. To the bulls that leaves room for plenty of further gains: at its narrowest, in June 2007, the spread on this index was 138 basis points (less than one-and-a-half percentage points).
That suggests bubble status is still some way off…
I thought this last line in bold was interesting. Buttonwood seems to imply that a bubble is developing in these bonds, but that it is still a ways off.
I think the bullish case for investing in emerging market funds (both stock and bond funds) has merit for the long haul because countries such as Brazil, India, China and others almost certainly will have higher rates of economic growth than developed economies such as Japan, Germany or the U.S. Over time, that higher rate of growth should be bullish for investments in those countries.
However, I would also point out that emerging market bonds have had quite a run from their low point. In other words, if you want to invest in this asset class, be prepared for some volatility and a fairly sharp pullback at some point.
In Part Two, I will review the argument for emerging market bonds being in a bubble, with particular emphasis on China. Also, I’ll give a couple of fund suggestions for those who want to invest in this area.
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Kurt Brouwer is a fee-only financial advisor with three decades of experience. He is the chairman and co-founder of Brouwer & Janachowski, LLC. Kurt has written books, articles and hundreds of blog posts on mutual funds, ETFs and other investment topics. E-mail: kurt.brouwer *at* gmail.com.
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