2018 was a tough year for bond investors. US Total Bond Market (represented by BND US ETF) returned -0.1% and Emerging Markets Bonds (represented by EMB US ETF) returned -5.5%.
Looking at last year’s returns, a logical question arose: what should we do with our exposure to Emerging Markets (EM) Bonds? Should we keep our allocation unchanged, reduce or eliminate it and replace it with US Treasuries?
The logical chain of thought dictates that investors require higher rates of return for higher levels of risk. If the FED is increasing rates, increased rates provide an option to have investments in safe government bonds with higher yields than before. It raises the required rate of return for taking higher risks, thus investors require higher yields on riskier assets for example EM bonds. It should also lead to a higher spread between EM Bonds and US Treasuries.
Let us look at the historical data.
Invesco has identified 9 periods with rising US rates since 1994 to 2016. The average change in the 10-yr US Treasury yield was 162 basis points. The average return for the US Treasury Index during those periods was -4.65%. Further, we look at how EM Bonds returns have compared to US Treasuries.
The above graph shows the difference between EM Bonds returns and US Treasury returns during previously identified periods. In 7 out of 9 periods, EM Bonds have outperformed or delivered higher returns in periods when US rates were rising.
EM Bonds are more volatile than US Treasuries, though investing in emerging markets debt over the long term has rewarded investors historically. Let us look at the example where an investor would enter the market at the “worst” possible time (at the beginning of 2007 before financial crisis).
J.P. Morgan EMBI Global Total Return Index (White), S&P 500 Total Return Index (Yellow), Bloomberg Barclays US Treasury Total Return Index (Pink)
J.P. Morgan EMBI Global Total Return Index (JPEIGLBL), S&P 500 Total Return Index (SPXT), Bloomberg Barclays US Treasury Total Return Index (LUATTRUU)
Over the chosen period of 01/01/2007-01/18/2019 the best performance was delivered by investments in the large cap stocks (represented by S&P 500 Total Return Index), in total returning 143% or 7.66% annualized. That’s after the recent fluctuations in global markets. EM Bonds returned 104.96% or 6.13% annualized while US Treasuries returned 51.27% or 3.49% annualized.
Further, we look at investments in EM Bonds from a mid-term investment perspective.
Source: Bloomberg, J.P. Morgan EMBI Global Total Return Index
The above graph shows annualized 3-year return for investments in EM Bonds. Since 1996, there has been only one 3-year period with a negative return for EM Bonds, with a total return -0.21%, or -0.07% annualized. The average total return for 3-year investment in EM Bonds since 1996 was 32.9% or 9.9% per annum.
We can conclude that rising US rates does not result in worse performance delivered by EM Bonds investments. Historically, EM Bonds on average have outperformed US treasuries in periods when US rates were rising. Over the long-term, EM Bonds have significantly outperformed US Treasuries. Furthermore, the average 3-year return per annum has been 9.9% since 1996. Increased allocation to US Treasuries could provide lower overall portfolio volatility in the short term, yet may position the portfolio to miss the potential higher performance of EM Bonds over a longer period.
FULL DISCLOSURE: Please note that the opinions expressed in this blog should in no way be considered as investment advice or a solicitation to buy or sell securities.