Emerging market bonds: Part of a resilient portfolio?

DESPITE a growing economic and technological decoupling between China and the West, the financial divide is actually shrinking. Capital from the US and Europe is flowing into China's bond market at an unprecedented pace, at least partly due to a search for attractive yield and high quality alternatives to US and European bonds.

Trickle, flow, gush

China's bond market - now the second largest in the world - has seen increased foreign participation, especially in its government bond market, where foreign ownership now exceeds 9 per cent, up from a negligible level just a few years ago.

The trickle that began in 2014, with a highly controlled quota system, turned into a steady inflow after the Chinese government loosened access and China earned inclusion into flagship bond indices.

Whether or not this accelerates into an outright gush will depend on the evolving needs of individual investors.

One clear motive behind the influx of capital into China's bond market is the search for yield. Chinese government bonds yield close to 3 per cent; higher-quality Chinese corporates can yield 4 to 5 per cent. With US Treasury yields as low as they now are, some American investors, who have been less aggressive than their European and Japanese peers in searching for yield beyond their domestic market, may step up investments in overseas bond markets.

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Remaining stable

Many of our clients have another, equally important motive: assets that are negatively correlated with equities. US Treasuries have been used as a bedrock of portfolio construction for more than 30 years, offering not simply diversification but also hedge value versus equities: an opportunity for capital gains when equity prices decline.

Even so, investors are considering other, complementary methods of portfolio stabilisation. While by no means a substitute for US Treasuries, Chinese bonds do contain similar hedging properties albeit with an elevated risk profile. Whereas the US five-year Treasury bond rallied by over 95 basis points (bps) and generated an over 4.5 per cent return during the March 2020 Covid-19 shock, the Chinese five-year government bond rallied 20 bps and generated a return of over one per cent. While one per cent was not as large a return, we believe Chinese bond yields still have ample room to rally.

The basket case

China is not the only market that offers the potential to offset equity risk with bonds that still have room to rally. Government bonds from a number of high quality emerging markets including Poland, the Czech Republic, Israel, Singapore, South Korea, Peru and Chile, among others, offer similar properties to varying degrees and risk levels.

In fact, a basket approach may offer more consistent hedge value than any single country. Historically, a basket of 10 high-quality emerging market bonds, including China, have followed moves in US Treasuries quite closely, and have also offered hedge value against global equities with a similar success rate. By diversifying across countries, investors also diversify away from country-specific idiosyncrasies, leaving a portfolio that may better track US Treasuries than any individual country.

The chart shows that yields on a basket of 10 high quality emerging market local five-year government bonds, with their currencies hedged to the US dollar, has tracked five-year US Treasury yields closely, declining from a little over 4 per cent in January 2008 to less than one per cent in July 2020. The basket includes the Malaysian ringgit, Czech koruna, Polish zloty, Singapore dollar, South Korean won, Thai baht, Chilean peso, Chinese yuan, Israeli shekel, and the Peruvian sol. The issuing countries are rated investment grade by either S&P, Moody's or Fitch.

The ability of a basket of high quality emerging market bonds to add ballast to a broader portfolio began to surface more than a decade ago as each country's financial infrastructure strengthened. This included independent and credible central banks, large institutional pools of savings in pension funds and insurance companies, and a dramatic reduction in debt denominated in anything but their local currency.

Alternative paths

Of course, if the motive is purely a negative correlation with equities, then it is important to hedge the currency risk associated with these bonds, which tends to be much more volatile than the underlying yields themselves. This can lower the yield net of hedging costs, but it preserves the hedge value of these bonds. And it may lower yields a lot less than one may realise - there is often an attractive cross-currency basis (an embedded premium on the currency hedging contract) available to US dollar-based investors, leaving them potentially better off in yield terms compared to US Treasuries.

The unknowns of the post-Covid-19 landscape demand greater attention to portfolio construction, and investors may wish to consider alternative paths to a more efficient portfolio and a diversified stream of returns.