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Do You Need Emerging-Markets Bonds?

On the EM local side, the yields are still reasonably appealing

Morningstar 25/07/17

Emma Wall: Hello and welcome to the Morningstar series "Ask the Expert." I'm Emma Wall and I'm joined today by Morningstar Investment Management's Tanguy De Lauzon.

Hello, Tanguy.

Tanguy De Lauzon: Hello, Emma.

Wall: So today we are talking about emerging-markets bonds. Firstly, I wanted to ask what is the appeal of this asset class?

De Lauzon: Well it's an asset class that’s quite appealing. So, you effectively have got two sections of that asset class. EM debt is issued in hard currency, so in dollar terms, so you got a spread on that and typically because those markets have lower quality, you get good spreads. So, it’s a way to enhance your returns while still having exposure to the U.S. curve principally. And then on the other side, you have got the emerging-markets debt issued in local currency and then you typically have pretty high yields due to the higher inflation, but also to the premium that are requested by investor to invest in those countries.

Wall: And of course, in developed markets over the last 10 years we have seen such record low yields that income investors, it's not surprising they've looked overseas to try and get a real return on their money. But there are risks associated with EMD, aren’t there?

De Lauzon: Yeah, definitely. So, effectively, investors have looked for and searched for yields, so went very much into those asset classes, but there are definitely significant risks. So, EM hard currency effectively you could see that something similar to high yield where you offer a high yield or high credit spread. But this is because the credit quality behind that is pretty high. And on the local currency side, obviously, you've got the currency risks. So, when everything goes well, that's potentially a contributor to returns. But when market sentiment turns down or when you have issues at the sort of sovereign health, then obviously the currencies can swing pretty really the wrong direction making that investment very risky.

Wall: And is it fair to say that default rates in emerging markets are much higher than those in developed markets?

De Lauzon: It is true definitely. We have seen a few of those countries defaulting on debts. You can think of LatAm countries had quite a few issues over the past years. So, it's definitely something to consider.

Wall: And with any investment, of course, you have got to weigh up the risks and the rewards. So, how can you use emerging-markets debt in your portfolio?

De Lauzon: So, typically, we see emerging-markets debt as sort of an hybrid type of investment with sort of income characteristics that are very appealing, especially for defensive portfolios. But also keeping in mind those risks that are elevated. So, we see it as a good way to diversify sort of gross investments, so slightly less risky than equities, but definitely more risky than bonds and so those hybrid characteristics when the valuations are attractive are effectively a very good way to enhance the risk/reward of your portfolio.

Wall: And emerging-markets debt carries higher yield than developed market debt at the moment. But it has come down, hasn’t it, much like the bond rally we've seen in the U.S., Europe, and the U.K. Yields are much lower now than they were a couple of years ago.

De Lauzon: Yeah. So, I think generally the health of many emerging markets have improved over the last few years. This has been recognized by investors. We have seen the yields coming down significantly. So, now close to a percent I think at the beginning of the year on local debt. Spreads on the hard sides have come down from over 400 basis points to now close to 300 basis points. So, definitely, a reduction in the yield offered by these markets, making them effectively less appealing now.

Wall: And of course, you operate a value-based investment strategy. So, presumably, this makes them less attractive to you now than they were a year ago, two years ago.

De Lauzon: Yeah, we were quite excited by those markets a year ago and now we're seeing the attractiveness has decreased significantly, mostly on the hard currency side effectively where the spreads are now below what we consider a fair value. And so, we don’t really feel we are paid for the risk or we were talking about default risk that we are taking. On the EM local side, the yields are still reasonably appealing. But on the currency side, so currency is obviously a big portion of the risk you carry with those, and at the moment, especially with the pound being at relatively cheap levels, this is not something that's likely to offer positive return in the future and definitely carries some risk. So, this is definitely an asset class that we find less and less attractive.

Wall: Tanguy, thank you very much.

De Lauzon: You are welcome.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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