Daily Telegraph
The risks are real but bonds issued by developing countries may be more rewarding than you think, says Robert Miller
Rising interest rates are usually bad news for bondholders, because it makes the fixed interest or "coupon" they pay relatively less attractive.
But, despite last week's interest rate rise in China - the first in nine years - investors in emerging market bond funds have generally been rewarded for accepting high risks in recent years. The average return from this sector has been nearly double the average from all types of pooled fund over the past five years.
Although their outperformance has been more marginal over the past year, these funds have tended to benefit from investors' worst fears not being realised by subsequent events. Even so, this is not an investment sector for widows and orphans. Emerging market finance ministers at last month's annual meetings of the World Bank and International Monetary Fund (IMF) in Washington made outspoken verbal assaults on the greed of the world's richest nations, demonstrating that investors in their bonds need strong nerves.
In this instance, bonds are IOUs issued by the governments of developing countries. Taken at face value, many of the ministers' attacks appear to convey the threat of government debt defaults - refusal to pay interest or capital - as happened most recently in Argentina.
"There's always a bad news story somewhere," says Paul Murray-John, the manager of the £86m Threadneedle Emerging Market Bond fund, who attended the meetings. "But investors must look beyond what is in large part political posturing and point scoring for a domestic audience. If you study the investment fundamentals which underpin emerging market sovereign [government] bonds it is quite another story."
Mr Murray-John, whose investments include bonds issued by the governments of Brazil, Turkey, Bulgaria, Venezuela and Russia, adds: "These emerging market countries need the foreign money raised on the international bond markets to help their domestic economies grow. They talk tough but actually work very hard to make sure they meet the requirements on financial reporting, timely debt repayments and other governance issues laid down by authorities such as the IMF."
The Threadneedle manager, who has run the fund since its launch in 1997 with Russian-born Igor Ojereliev as his deputy, concedes that for many investors, and particularly risk-averse ones, putting money in emerging market bonds, even if they are issued by governments rather than companies, is a big step.
"But what is the alternative?" he asks. "In the past, UK gilts - bonds issued by the British Government - have yielded enough to meet the requirements of the most risk-averse investors. That is no longer the case. I would argue strongly that if you want to take risks with your portfolio, then you are fully invested in equities. If you want income, then emerging market bonds should be seriously considered as a fully fledged asset class."
However, no bond is any better than its guarantor. The risk with high yielding bonds is that the price of a good income today could be capital erosion tomorrow.
Threadneedle's fund, which offers an average yield of 8.15 per cent to maturity, is one of two emerging market bond funds domiciled in the UK and authorised by the Financial Services Authority, and therefore covered by the official compensation scheme, which pays a maximum of £48,000 in the event of a default. The other is run by M&G.
There are more than a dozen other funds listed under the Standard & Poor's "fixed income global emerging markets" category that are based in Luxembourg and Ireland.
A spokesman for the FSA explains that some, but not all, of these funds are covered by the UK compensation rules because their parent management company is supervised directly by the UK watchdog.
He adds that all EU states must now by law have a compensation net for investors which covers 90 per cent of an investment up to a maximum of 20,000 - about £13,900, less than half the UK safety net. Some do pay more. He advises investors to check the standing of a particular fund before buying.
As a rule of thumb, most of the S&P listed emerging market fixed income and bond funds steer clear of corporate bonds - IOUs issued by local companies. "We don't do corporate," says Mr Murray-John. "You need a huge team on the ground and it can be very hard to do a proper investigation of the reports and accounts. You've also got the currency risk, which you don't have in the sovereign bond market because it is all traded in dollars."
Jerome Booth of Ashmore Investment Management, which specialises in emerging market debt, says: "There is massive prejudice among investors against emerging market bonds.
"You have got this big equity culture here in the UK and in the US and yet they ignore an asset class such as emerging market sovereign bonds which produce very attractive yields."
Investors with long memories may, however, recall the various Mexican financial crises of the 1970s and 1980s and the huge debt defaults in Latin America of the past decade - not to mention the crash that leapt from Brazil to Russia in 1998.
Mr Booth points out that today's politicians in charge of emerging market countries recognise that they must follow the rules on "openness and accountability" set down by the IMF and other bodies. "And," he adds, "you always need liquidity. Trading in global emerging market sovereign bonds is currently valued at around $3trillion. That's more than twice the value or liquidity of the FTSE 100 Index."
A lot of the new money that underpins emerging market bonds at present comes from big pension funds in the UK, US and Europe, according to Mr Booth. "It is very definitely an established trend now that pension funds have been forced to look for higher returns to cover widening deficits. Equities alone are simply not going to do that.
"Of course, there are risks," he adds. "But investing in property is a risk. So, too, is putting all your money into one asset class and one country, even if it is the UK. Look at it this way. You've got around 85 per cent of the world's population in emerging market countries. That's where the real economic growth and new markets will come from in the foreseeable future."
Keith Swabey, managing director of JP Morgan Fleming's fixed income division, says: "Everybody is risk-averse and I'm not suggesting that you come straight out of UK gilts and go for emerging market bonds. Take it a step at a time where, on the risk scale, gilts are one and emerging market sovereign bonds are five. But they have produced spectacular gains over the past few years compared with other asset classes and therefore deserve serious consideration."
What about future prospects? Mr Swabey says: "I think the biggest single risk comes from the dollar and the currency hit if US interest rates rise more quickly than anticipated. That would reduce the returns for UK investors. To put that in perspective, however, I'm talking about a total return of maybe 5 per cent or 6 per cent rather than the 6 per cent to 8 per cent you might expect if US rates rise more slowly, as predicted."
Martyn Ingram is a specialist fund analyst at Investors Partnership, which advises intermediaries such as independent financial advisers. For investors considering emerging market bond funds, he suggests: "Narrow the list down to those funds fully covered by the UK compensation scheme. As for your manager, you want someone who understands the politics and economics of emerging market countries. You want them to interpret the trends and to be there ahead of the crowd."
Mr Ingram's firm recommends Threadneedle's Emerging Markets Bond fund as well as the High Income rival run by Paul Thursby at Thames River. The fund analyst acknowledges that annual charges of around 1.5 per cent are steep but adds: "The right manager will make sure the performance of the underlying portfolio generates a total return that should more than outweigh the extra expense."
Rising interest rates are usually bad news for bondholders, because it makes the fixed interest or "coupon" they pay relatively less attractive.
But, despite last week's interest rate rise in China - the first in nine years - investors in emerging market bond funds have generally been rewarded for accepting high risks in recent years. The average return from this sector has been nearly double the average from all types of pooled fund over the past five years.
Although their outperformance has been more marginal over the past year, these funds have tended to benefit from investors' worst fears not being realised by subsequent events. Even so, this is not an investment sector for widows and orphans. Emerging market finance ministers at last month's annual meetings of the World Bank and International Monetary Fund (IMF) in Washington made outspoken verbal assaults on the greed of the world's richest nations, demonstrating that investors in their bonds need strong nerves.
In this instance, bonds are IOUs issued by the governments of developing countries. Taken at face value, many of the ministers' attacks appear to convey the threat of government debt defaults - refusal to pay interest or capital - as happened most recently in Argentina.
"There's always a bad news story somewhere," says Paul Murray-John, the manager of the £86m Threadneedle Emerging Market Bond fund, who attended the meetings. "But investors must look beyond what is in large part political posturing and point scoring for a domestic audience. If you study the investment fundamentals which underpin emerging market sovereign [government] bonds it is quite another story."
Mr Murray-John, whose investments include bonds issued by the governments of Brazil, Turkey, Bulgaria, Venezuela and Russia, adds: "These emerging market countries need the foreign money raised on the international bond markets to help their domestic economies grow. They talk tough but actually work very hard to make sure they meet the requirements on financial reporting, timely debt repayments and other governance issues laid down by authorities such as the IMF."
The Threadneedle manager, who has run the fund since its launch in 1997 with Russian-born Igor Ojereliev as his deputy, concedes that for many investors, and particularly risk-averse ones, putting money in emerging market bonds, even if they are issued by governments rather than companies, is a big step.
"But what is the alternative?" he asks. "In the past, UK gilts - bonds issued by the British Government - have yielded enough to meet the requirements of the most risk-averse investors. That is no longer the case. I would argue strongly that if you want to take risks with your portfolio, then you are fully invested in equities. If you want income, then emerging market bonds should be seriously considered as a fully fledged asset class."
However, no bond is any better than its guarantor. The risk with high yielding bonds is that the price of a good income today could be capital erosion tomorrow.
Threadneedle's fund, which offers an average yield of 8.15 per cent to maturity, is one of two emerging market bond funds domiciled in the UK and authorised by the Financial Services Authority, and therefore covered by the official compensation scheme, which pays a maximum of £48,000 in the event of a default. The other is run by M&G.
There are more than a dozen other funds listed under the Standard & Poor's "fixed income global emerging markets" category that are based in Luxembourg and Ireland.
A spokesman for the FSA explains that some, but not all, of these funds are covered by the UK compensation rules because their parent management company is supervised directly by the UK watchdog.
He adds that all EU states must now by law have a compensation net for investors which covers 90 per cent of an investment up to a maximum of 20,000 - about £13,900, less than half the UK safety net. Some do pay more. He advises investors to check the standing of a particular fund before buying.
As a rule of thumb, most of the S&P listed emerging market fixed income and bond funds steer clear of corporate bonds - IOUs issued by local companies. "We don't do corporate," says Mr Murray-John. "You need a huge team on the ground and it can be very hard to do a proper investigation of the reports and accounts. You've also got the currency risk, which you don't have in the sovereign bond market because it is all traded in dollars."
Jerome Booth of Ashmore Investment Management, which specialises in emerging market debt, says: "There is massive prejudice among investors against emerging market bonds.
"You have got this big equity culture here in the UK and in the US and yet they ignore an asset class such as emerging market sovereign bonds which produce very attractive yields."
Investors with long memories may, however, recall the various Mexican financial crises of the 1970s and 1980s and the huge debt defaults in Latin America of the past decade - not to mention the crash that leapt from Brazil to Russia in 1998.
Mr Booth points out that today's politicians in charge of emerging market countries recognise that they must follow the rules on "openness and accountability" set down by the IMF and other bodies. "And," he adds, "you always need liquidity. Trading in global emerging market sovereign bonds is currently valued at around $3trillion. That's more than twice the value or liquidity of the FTSE 100 Index."
A lot of the new money that underpins emerging market bonds at present comes from big pension funds in the UK, US and Europe, according to Mr Booth. "It is very definitely an established trend now that pension funds have been forced to look for higher returns to cover widening deficits. Equities alone are simply not going to do that.
"Of course, there are risks," he adds. "But investing in property is a risk. So, too, is putting all your money into one asset class and one country, even if it is the UK. Look at it this way. You've got around 85 per cent of the world's population in emerging market countries. That's where the real economic growth and new markets will come from in the foreseeable future."
Keith Swabey, managing director of JP Morgan Fleming's fixed income division, says: "Everybody is risk-averse and I'm not suggesting that you come straight out of UK gilts and go for emerging market bonds. Take it a step at a time where, on the risk scale, gilts are one and emerging market sovereign bonds are five. But they have produced spectacular gains over the past few years compared with other asset classes and therefore deserve serious consideration."
What about future prospects? Mr Swabey says: "I think the biggest single risk comes from the dollar and the currency hit if US interest rates rise more quickly than anticipated. That would reduce the returns for UK investors. To put that in perspective, however, I'm talking about a total return of maybe 5 per cent or 6 per cent rather than the 6 per cent to 8 per cent you might expect if US rates rise more slowly, as predicted."
Martyn Ingram is a specialist fund analyst at Investors Partnership, which advises intermediaries such as independent financial advisers. For investors considering emerging market bond funds, he suggests: "Narrow the list down to those funds fully covered by the UK compensation scheme. As for your manager, you want someone who understands the politics and economics of emerging market countries. You want them to interpret the trends and to be there ahead of the crowd."
Mr Ingram's firm recommends Threadneedle's Emerging Markets Bond fund as well as the High Income rival run by Paul Thursby at Thames River. The fund analyst acknowledges that annual charges of around 1.5 per cent are steep but adds: "The right manager will make sure the performance of the underlying portfolio generates a total return that should more than outweigh the extra expense."
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