Hunting for Yield Overseas

Hunting for Yield Overseas

Posted On July 19, 2016 2:43 pm

As the developed nations continue to punish savers by pounding yields below the zero bound there are some interesting alternatives in the emerging market bond funds.

Already one third of all developed nations’ sovereign debt, some $4 trillion worth including German, Swiss and Japanese bonds, now sporting negative interest rates. This leaves retiring baby boomers, pension funds, insurance annuities and anyone seeking stable income in a desperate state. And given the expectation for the Bank of England to join the party and the belief Yellen and company is in no hurry hike the hunt for yield is likely to become increasingly intense.

Thus far investors have been piling into dividend paying stocks such as utilities, consumer staples and REITs. Basically, these stocks have been treated as “bond equivalents” but this has pushed valuations to hit historical highs; levels many feel are nearing a breaking point. Remember, it doesn’t take too big a dip in share price to wipe out a year’s worth of a 3% dividend—no matter how seemingly stable their businesses they do still carry stock risk.

I think the next shore upon which this wave of money sloshing around looking for a relatively risk free rate of return will land is emerging market bonds. After the German bund went negative and the Brexit weakened the pound money came rushing from Europe into the U.S. bonds for their relatively high yield; this has driven yield the 10-Year Note down below 1.5% in recent weeks. I believe a similar arbitrage will cause money to flood into emerging market bonds as money seeks the higher yield differential they offer.

Emerging Bonds Already Arrived

Back in the late 1980’s and 1990’s emerging market bonds–that is bonds issued by the governments such countries such as Brazil, Mexico, India, etc–were considered both risky and exotic.

The former because the countries truly were just “emerging” with many having unstable governments, minimal economic output and rampant inflation often in excess of 30%. All this added up to a high risk of default.   For this risk investors got paid with bonds that offered annual yields of 10%-15% and sometimes more.

They were considered exotic because only the largest institutions or sophisticated investors had access. One needed to be able to purchase the bonds directly from the local government or their local intermediaries. Not many U.S. based investors can open Turkish, Malaysian or Chilean bank accounts, let alone all three or more.

The risk issue has greatly diminished as the countries’ governments have stabilized, the economies’ improved and inflation came down to at least more manageable levels.

These bonds became less exotic as globalization spurred capital, both corporate expansion and speculative investments, to flow to where it would be best paid. In the early 2000’s that meant into emerging markets, made well known by the ‘BRIC’ acronym, where the demographics of youthful population, urbanization and incipient consumer driven middle class was delivering double digit GDP growth.

But it took the financial crisis to make these investing in these bonds accessible to U.S. retail investors. During the crisis of nearly all asset classes, from equities to commodities and of course real estate, suffered leaving investors that thought they were diversified discouraged. The one safe haven was U.S. Treasuries.

But then rate cuts and QE programs drove yields down to starvation levels. So as the crisis passed investors started looking for not only higher yields but ways to diversify. And the financial industry was there to oblige by launching a host of emerging market ETFs which bundled a bunch of bonds providing some price stability but still delivered attractive yields.

Today there a number of ETF’s such as PowerShares Emerging Market Sovereign Debt (PCY) and iShares JPMorgan USD Emerging Markets Bond (EMB ) that each have over $8 billion in assets under management (AUM).  

They pay dividends with a current approximate yield of 5% per year and each trade over 1 million shares a day providing good liquidity. Additionally, the shares have been on a tear, enjoying capital appreciation of some 10% thus far this year and all sit near 52-week highs. 

Is it Safe?

While much of luster has left the BRICs of late they still have several positives going for them; decent, if unspectacular growth rates, increasingly diversified economies with growing middle classes and, except for a few nations which have become untouchable, peaceful and stable governments.

But most importantly their Debt levels are far lower as a ratio to GDP than any of the developed nations. For example, while household debt to GPD in the U.S., Japan and France are all above 100% it stands at just 9% in India, 22% in Brazil and 31% in Mexico. Emerging market governments have accumulated less dollar debt, built up foreign reserves and adopted flexible exchange rates to obviate mistakes during the 1980s and 1990s crises.

Blackrock has recently been recommending investors take the theme a step further and suggests investing in these bonds using the local currency writing in a recent report, “Developing countries such as Brazil and the original Asian Tigers all took their medicine two decades ago and now have much better balance sheets than the developed world. So while the race to debase remains in place in the developed world as Draghi, Abe and now England’s Carny crank up their printing presses emerging market currencies should show rise relative strength.”

The higher yields offered by Brazil or Turkey, while certainly due to many of the economic and potentially political challenges, are also simply a remnant of a different decade when inflation conflict ran rampant. They also note that even for portfolios that seem to diversified among various asset classes they are usually all dollar denominated.

Some ETFs that focus emerging markets bonds denominated in local currencies include Market Vectors Emerging Markets Local Currency (EMLC) and Wisdom Tree Local Debt (ELD) and iShares Emerging Market Local Currency Bond (LEMB). These funds own government issued bonds that have an investment grade rating and the yield is simply the coupon payment. They offer some 5% dividend yield and have decent

While the currency component can add to volatility it should provide a nice tailwind over the next few months as the developed nations continue to punish savers by pounding yields below the zero bound. For those looking for yield and diversification away from the dollar these funds make sense.

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.