Emerging market bonds - an outlook

Emerging Markets are commonly defined as financial markets of developing countries. Countries normally falling in this category include those in Latin America, East Asia (excluding Japan) and Eastern Europe.

In the vast majority of cases, emerging debt instruments have offered investors high returns. An emerging sovereign bond for example would typically pay at least 400 bps to 600 bps over and above the coupon rate of investment grade bonds. However, consistent with the risk return trade-off inherent in all investments the associated risks are also much higher.

Returns and the risks attached to these investments are generally a reflection of political and financial stability, future economic prospects, returns from investments in developed countries, liquidity concerns, risks of default (issuer credit worthiness) and much more.

Emerging market bonds have for the last three years been one of investor's top portfolio selections. This was due to the fact that interest rates were falling, equity markets were bearish and consequently emerging market sovereign bonds offered investors adequate returns given the level risk.

Given this context, what is the outlook for emerging markets given today's economic position and what are the risks one needs to be aware of in the short to medium term?

Emerging market bonds performed very well with prices reaching high levels over par value as a result bonds are now paying much less over the investment grade bonds.

Does this mean that they are overpriced? To justify this return, the risk involved in such bonds must be reduced accordingly. Emerging market bonds are not homogenous and thus risk differs. In fact, there is a wide spectrum of emerging market bonds with different ratings however, those issues with ratings of CCC or lower have poor economic fundamentals and less political stability than others. Thus there are various issuers whose bond prices do not truly reflect the risk involved.

Bond prices, whether of high quality or not, are negatively affected by increases in interest rates. With respect to emerging market bonds this problem is aggravated by the fact that interest rate risk is not limited to one country only. Fluctuations in interest rates in Europe, the US and the UK all bear consequences on emerging market bond prices since investors view these rates as risk free indicators.

In this regard, following the excellent economic performance of most economic blocks around the world during 2003, central bankers have altered their policy stance. Over the last four months the Bank of England has raised interest rates twice, the Federal Reserve Bank is also contemplating increasing interest rates. Higher interest rates in the US and elsewhere will cause a reduction in bond prices (lower capital flows into emerging market economies). These factors represent a significant risk exposure for persons holding or considering purchasing emerging market bonds (bond prices are expected to be more volatile especially the long-term bonds).

Finally, bullish equity markets driven by positive economic and corporate results will unmistakable cause a shift in investors' asset allocation. Equities will over the next six months take up a larger composition of an investor's total portfolio. This shift could adversely affect bond prices.

Even though the table is starting to turn on emerging market bonds investors need not despair. Emerging market bonds have over the longer term consistently provided good returns to investors. The recent negative risk factors simply imply that investors need to be more aware of possible pitfalls in these investments and move around them in order to protect their portfolios. How?

Persons holding direct bonds with the intention to hold them until maturity need not worry so much on the interest rate risk. These investors are typically interested in the income paying component of the investment. In this regard they must simply pay attention to the issuers on going credit worthiness and other risks typically associated to such bonds.

Potential and existing investors must avoid some of the above mentioned risk by adequate diversification across various currencies and bond issuers (corporates and well as government bonds). Holding bonds denominated in different currencies euros or sterling and US dollars can offer some protection against currency risk.

Finally, investors must remember the cardinal rule of investing in short dated bonds in times of interest rate increases. Also investors must not forget the advantages of managed bond funds. Such professionally managed funds offer a good diversification to investors thus reducing the risk exposure when compared to investing directly into one particular issuer.

Investors who do not wish to invest solely in emerging market bonds can today avail themselves of funds which diversify the portfolio between these bonds and investment grade bonds.

Mark Azzopardi, MA Finance; B.Com., is investment and finance director of Jesmond Mizzi Financial Services Ltd. e-mail: mazzopardi@jmfs.net

The value of investments can go down as well as up. Past performance is no guarantee for future performance. This article does not intend to give investment advice and the contents therein should not be construed as such. Readers are encouraged to seek professional advice regarding their personal financial situation.