How to Invest in Emerging Market Bonds

SmartAsset: How to Invest in Emerging Market Bonds

If you’re like most investors, your exposure to the bond market is likely limited to U.S. government debt. Treasury bonds have been popular investments for consumers since World War II and are by far the most well-known major debt instruments. These are, however, just the tip of the iceberg. The bond market includes debt from major corporations, banks and municipal governments. And growing in popularity are emerging markets.

If you’re interested in emerging market bonds, a financial advisor can help you understand how they fit into your financial plan.

What Are Emerging Market Bonds?

Emerging market bonds are bonds issued by governments or corporations in developing nations. These are considered “emerging markets” because they have historically had limited investment value, but have recently become more stable and creditworthy environments in which to invest.

Like all major bonds, emerging market bonds are fixed-income. This means that the borrower makes regular payments at a set interest rate (known as the bond’s “coupon rate”), then repays the face value of the note at the end of its term. These bonds will also typically mature over a long period of time, often five, 10 or 20 years for a single note, similar to conventional bonds.

Two things distinguish an emerging market bond from investing in a domestic or conventional debt instrument:

Economy. The bond has been issued by a government or private corporation in a country that is considered an emerging economy. This definition can vary. For example, some investors still consider Brazil an emerging economy, while others would argue that this perspective is out of date.
Currency. The bond may be denominated in the currency of the emerging market. This is not always true, however, as even many foreign markets lend and borrow in U.S. dollars.

When issued in the currency of the foreign nation, emerging market bonds are also sometimes known as “local currency bonds.”

Major Considerations for Emerging Market Bonds

There are three major points to consider when it comes to emerging market bonds:

Default and repayment. Bonds issued from developing economies have a higher rate of default and risk than conventional instruments. This is due to a number of factors, including economic uncertainty, market weakness, political instability and local corruption. The risk of any particular emerging market depends entirely on that particular country, as do the details of that risk.

However, emerging market bonds have become more popular in recent years as many of them grow steadily more creditworthy and rates of default have decreased.

Interest rates. Due to the risk surrounding emerging economy bonds, they tend to pay higher rates of interest than bonds issued either by either companies or governments in places like the United States or Europe.

Currency fluctuations. As noted above, many emerging market bonds are issued in U.S. dollars. For these notes, currency is not a factor.

For bonds issued in the local currency of an emerging market, exchange rates become an additional factor for profits and loss. If the local currency gains value against the U.S. dollar, it will make your bond’s yield and eventual repayment more valuable in turn. If, however, the currency declines against the U.S. dollar, the bond will lose value.

As a result, many investors see emerging market bonds as a currency investment as well as a debt investment. They will buy these bonds in the hopes of capturing the gains when the underlying currency gains value.

For example, say someone buys a bond from the Thai government worth $1 million Thai baht with a 5% interest rate paid every six months. At the time of their purchase the baht traded at $0.30 to 1 baht. This makes their bond worth $300,000 total, with a $15,000 payment every six months. Now say that the baht increases in value and trades at $0.33 to 1 baht. This bond would then be worth $330,000, with a payment of $16,500 every six months.

However, it is important to note the risk here. While our investor could make an extra $3,000 per year just from currency fluctuations, they could lose that money just as easily. Say, in our example, the Thai baht declines to $0.27 to 1 baht. Now the bond is worth $270,000, with coupon payments of only $13,500.

Note that this is not a likely factor when a currency has been pegged to the U.S. dollar. In that case, currency fluctuations are unlikely.

Sovereign Risk and Emerging Market Bonds

Sovereign risk is the concern that a country will make policy choices that cause a bond to lose value. This can include, among other concerns:

Nonpayment of government bonds
Intentional devaluation of the currency
Foreign exchange limitations
Foreign capital limitations

For example, say a country makes the political decision to block capital outflows. This would prevent investors from transferring their bond payments out of the local bank and into their domestic bank back home. As a result, your bond would be worth far less, because you would have to travel to that country in order to access or spend the money.

Another example of sovereign risk is the ongoing debate in the U.S. government over the nation’s debt ceiling. Failure to raise the debt ceiling at any given time could cause the United States to default on many of its outstanding debts. This would be a deliberate nonpayment, an example of sovereign risk in action. The degree to which it has become a part of U.S. political culture is what led two global credit rating agencies, Standard & Poor’s and Dagong Global Credit Rating, to downgrade the credit rating of the American government.

The reduction of sovereign risk in many emerging markets has driven increased interest in emerging market bonds.

The best, if not only, way for an individual investor to access emerging market bonds is through a mutual fund or ETF. Many major brokers run funds built out of emerging market bonds, including Vanguard, JP Morgan and Fidelity.

Funds like this will hold bonds issued by emerging markets, both the governments themselves and private companies. For example, one representative fund (the Fidelity New Markets Income Fund) holds debt instruments issued from countries such as Mexico, Turkey, Argentina and Ukraine.

One reason to opt for a mutual fund or ETF is that high-quality research on emerging market bonds is often difficult to obtain or, in some cases, not available at all. A fund’s assortment of securities reduces the risk investors take when putting their money into a emerging market bond for which there is little to no independent, professional research.

Funds also solve a practical problem. An individual typically can’t buy these bonds directly for the same reason that individuals can rarely directly purchase domestic bonds. Buyers generally need to make large, multi-million dollar purchases on markets that require more sophistication than the average investor possesses.

Bottom Line

Emerging market bonds are debt instruments issued from governments and corporations in developing nations. They tend to have higher risk and higher interest rates than comparable instruments from advanced economies but in recent years are seen as a more reliable investment.

Bond Investing Tips

Consider talking to a financial advisor about investing in emerging market bonds. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Emerging market bonds have domestic equivalents that can be a valuable part of an investment portfolio. We explain exactly what a bond is and how you, individually, can get into that market.