Investing: Risk and reward

From inside a brown brick building overlooking Boston Harbor, Mark Venezia and his team gather the kind of data the CIA probably collects on a regular basis. They track political manoeuvres inside oil-rich countries in the Middle East; they assess the likelihood Hosni Mubarak, Egypt’s 80-year-old president, will survive another term in office; they read stuff written in Cyrillic. But their activities are anything but top secret. Venezia is head of the global bond department for Eaton Vance (nyse: EV), a Boston-based asset management company. He is a macroeconomist and currency analyst — not a spook. But what his intel suggests might scare you nevertheless: emerging-market local government bonds could be strong performers in the years ahead.

For many investors, assets denominated in an emerging-market currency will conjure up visions of rapid devaluation. But Venezia says times have changed. Through a combination of stable financial institutions, free-market reforms and central banks’ keeping inflation and exchange rates in check, there’s greater trust in emerging-market bonds. “There haven’t been many currency devaluations in the world partly because of these policies,” Venezia says.

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Emerging-market local bonds are also becoming a distinct sector. Except for the last few weeks, which have been full of bad economic news, these assets haven’t really moved in tandem with global equity markets. In other words, Venezia says, emerging-market bonds could be part of a diversification strategy that lowers portfolio volatility.

Venezia is banking that the U.S. dollar will depreciate under the stress of the country’s massive current account deficit. That will boost his returns on local government bonds in emerging markets. But he also says interest rates could fall in developing countries. And, as we all know, bond values go up when interest rates fall and vice versa. In general, Venezia says, governments in emerging markets have been raising rates in response to inflation caused by higher commodity prices. “Well, raising interest rates, when you know the U.S., Europe and Japan are going down the drain, was crazy,” he adds. With the global economy slowing and commodity prices falling, “many of these central banks are now switching to monetary easing.”

Emerging-market local bonds look expensive on a historical basis, says Nick Chamie, the global head of emerging-markets research at RBC Capital Markets. Investors ploughed money into developing countries from 2001 until 2007; now the market is in a period of adjustment. “Foreign investors make up an important part of an investor base in emerging markets,” Chamie says, “and what typically happens in a corrective phase is the home bias kicks in and you see funds move out of emerging markets and back into the U.S., Europe and Japan.” Still, Chamie says it may be time to look for opportunities, but he won’t be downright bullish until U.S. financial markets stabilize, leading indicators in the developing world improve, and the spread narrows between emerging market bonds and similarly rated U.S. corporates.

When that last criteria is met depends on circumstances, but Chamie says emerging-market bonds will become more attractive when yields are 75 to 100 basis points below U.S. corporate bonds with similar credit ratings; the current spread is about 155 basis points. That said, he expects bonds from Mexico, Panama, Chile, Russia and Brazil will outperform those from other developing countries in the years ahead, because their governments generally have low financing needs and stable and improving credit ratings.

Mutual funds provide one way to play emerging-market local bonds. For example, the Eaton Vance Emerging Markets Local Income Fund invests in these assets in eastern Europe, Latin America, and Central and East Asia. There’s also an exchange-traded fund, iShares Emerging Market Bond ETF (nyse: EMB), which tracks the JPMorgan EMBI Global Core Index. Both, however, expose Canadians to the exchange-rate risk, since they’re denominated in U.S. dollars. But with no signs of recovery in the global equity markets, broadening your portfolio’s horizons and assets could be a smart move.

 

 

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