Fixed IncomeMay 24 2013

Take 5: Emerging market bonds

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ByDaniel Liberto

Emerging market debt has seen its stock rise in recent years as investors seek new income opportunities away from western government bond yields that barely edge above inflation.

Despite emerging nations often being synonymous with political upheaval, sharp economic swings and financial mismanagement, nowadays governments of these nations are, in general, better at managing debt than their western counterparts.

With a number of different options available that include active and passive exposure and hard and soft currencies, here our our top tips on how to approach investments in this sector.

1. Keep tabs on frontier markets. Despite being marketed as emerging market bonds, some funds in this sector do also occasionally invest in the lesser-developed frontier nations. If your client is ok with extra risk then this is not necessarily a bad thing, but be warned that the added reward comes with a higher possibility of default.

2. Decide on active or passive. As the sector evolves, there are now a number of exchange traded funds (ETFs) that offer investors passive exposure to the emerging market bond market. For those keen to track the overall market this presents a valid option, rather than specialising in a specific sector via an active manager who aims to outperform the index.

3. Be aware of different currency options. While these bonds were previously only issued in US dollars and British pounds, nowadays investors can also get exposure to local currencies too. Although the benefits of local currency should not be dismissed, risk-averse investors should probably steer clear of them.

4. Diversify. Around 60 per cent of emerging corporate debt is now rated investment-grade, so a slight exposure to junk bonds is not necessarily a bad idea. Be sure to check out the portfolio breakdown of each fund to better understand the competitiveness of yields and how they compare to potential risk.

5. Do your homework on country weightings. The higher the likelihood of potential default, the higher the yield coupon is likely to be. However, it is worth weighing up the risk factors and geopolitical stability of each country in question to ensure your client’s risk exposure matches expectations.

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