Are Emerging-Market Bonds Worth the Risk?

Emerging-market (EM) bonds have been exceptionally volatile since the onset of the COVID-19 crisis. In March, prices dropped 16% in a matter of weeks, resulting in the worst monthly decline since 2008.1 After central banks stepped in to provide liquidity, EM bonds rebounded sharply in the second quarter. Year to date, the total return for U.S.-dollar-denominated EM bonds is up 2.1%, while local-currency bond total return is down 1.9%.

Emerging-market bond total return has been volatile


Source: Bloomberg Barclays Global Aggregate Total Return Bond Index, Bloomberg Barclays Emerging-Market U.S. Dollar Aggregate Total Return Bond Index and Bloomberg Barclays Emerging-Market Local Currency Government Total Return Bond Index. Daily data as of 7/22/2020. Past performance is no guarantee of future results.

Weighing the ongoing risks of the virus against the extra yield the bonds provide, begs the question: Is an allocation to EM bonds worth the risk? The short answer is yes—but only for investors with the tolerance and capacity for risk. We believe an allocation to EM bonds can still provide income and diversification to a fixed income portfolio, but it is likely to come with a lot of volatility.

While emerging-market bonds have rebounded off the depressed lows of March, spreads are still generally wide, presenting opportunities for those willing and able to accept the risks. EM bonds are not an asset class for the faint of heart—those with little tolerance or capacity for the volatility, lack of liquidity, and potential loss should turn back now. For those of you who are still interested, here’s what you need to know.

The emerging-market debt universe has grown

The universe of emerging-market bonds has grown rapidly over the years—from $885 billion in 2008 to $2.7 trillion in 2020.2 Sovereign bonds—those issued by governments—comprise the bulk of the market, but issuance of corporate bonds is growing and now makes up 26% of the universe. With interest rates in major developed countries near zero or even negative, EM countries and corporations have found eager buyers of their bonds as investors search for higher yields.

Over the years, China has issued an increasing amount of debt, dwarfing the rest of the emerging-market debt universe, especially in the case of local-currency sovereign bonds. Also worth noting is that the USD-denominated index has more exposure to oil-producing countries.

The USD EM bond index and the local-currency EM bond index are very different


Note: Shows the top 10 weights by country in each respective index.
Source: Bloomberg Barclays Emerging-Market U.S. Dollar Aggregate Total Return Bond Index, as of June 2020 (left chart). Bloomberg Barclays Emerging-Market Local Currency Government Total Return Bond Index, as of June 2020 (right chart).