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Emerging market bonds: Looking beyond the headlines

July 01, 2013

Should you invest in emerging market bonds? It's a question many Vanguard clients are asking now that we've introduced an index fund focusing on this small but growing component of the global fixed income marketplace.

A new Vanguard research paper takes a close look at the emerging market bond environment, including the pros and cons for U.S. investors. The conclusion: If you hold a diversified portfolio with broad international exposure, you may already have sufficient emerging market exposure. Additional exposure may not be necessary or wise given the current footprint these bonds have in the global market. However, if you're looking for greater diversification in your fixed income allocation and are a risk-tolerant investor, a separate allocation to emerging market bonds is certainly worth considering. But don't proceed without giving equally careful consideration to the risks involved.

Following is a high-level summary of our research paper, or you can download the full version.

Background: A growing appeal for global investors

What's the right allocation to international bonds?

Chris PhilipsIn a recent interview, Vanguard senior investment analyst Chris Philips offered food for thought to investors considering international bond exposure—whether in emerging markets or in the full global bond marketplace.

Read the interview »

As of December 31, 2012, the total value of debt issued in emerging market nations such as Brazil, Russia, India, Turkey, and China was about $2.7 trillion, Barclays reported, with more than 90% of that issued by governments or government-related entities.

Perhaps contrary to common perception, the majority of this debt is considered investment grade by the major rating agencies. And indeed, investors have responded enthusiastically: From 2008 through the end of 2012, mutual funds and exchange-traded funds (ETFs) focused on emerging market debt took in almost $64 billion in new investments (cumulatively), with almost $28 billion in 2012 alone, according to the independent rating group Morningstar, Inc.

There's little mystery behind the appeal of emerging market bonds. The fixed income market in the United States has been characterized by low yields and a return outlook that's muted at best. At the same time, bonds in many emerging market countries have offered attractive yields and strong historical performance against a backdrop of improving macroeconomic fundamentals. Thanks in part to greater fiscal and political discipline—along with the corresponding establishment of foreign reserves and stabilized inflation—central banks in many of these countries have gained credibility, and many have experienced robust economic performance and financial market development. This has led to rating upgrades, further inflows of capital, and rapidly improving credit markets.

These factors, among others, have contributed to the groundswell of interest in emerging market bonds. After conducting considerable research into the subject, we introduced (in May 2013) Vanguard Emerging Markets Government Bond Index Fund, which seeks to track the Barclays USD Emerging Markets Government RIC Capped Index.

Risk factors to consider before investing

While all investments are subject to risk, a quick glance at the latest news headlines will remind investors of the unique risks involved with emerging markets. Political upheaval, financial troubles, and vulnerability to natural disasters are important to consider, as is the chance that bonds issued in emerging markets will be substantially more volatile (and substantially less liquid) than bonds issued in more developed markets.

There's also the historical tendency—discussed at length in our new research paper—for emerging market bonds to perform more like stocks than like traditional bonds. While the record shows that adding emerging market bonds to a diversified portfolio would have improved total return, the trade-off has been greater volatility (comparable to that associated with high-yield bonds, as opposed to traditional investment-grade bonds) and increased sensitivity to global economic and political events. A key question, therefore, is whether the benefits of investing in emerging market bonds are adequate compensation for the risks involved.

Another consideration: If your portfolio already includes substantial global diversification, investing in an emerging market bond fund might create "asset overlap" or "overweights" in your portfolio—that is, holding multiple positions in the same security or overweighting an asset class relative to its size in the capital markets. For example, Vanguard Total Bond Market Index Fund also invests in emerging market bonds denominated in U.S. dollars. If you already have broad-market bond exposure, be sure to assess your existing emerging market exposure before making the decision to add more.

Similarly, it's also worth noting that many broad-based international bond funds such as our newly introduced Vanguard Total International Bond Index Fund contain exposure to emerging market debt denominated in local currencies.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Investments in bonds are subject to interest rate, credit, and inflation risks. Bonds from emerging markets are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments. They are also subject to country/regional risk, which is the chance that political upheaval, financial troubles, or natural disasters will adversely affect the value of securities issued by foreign governments, and emerging market risk, which is the chance that bonds of governments located in emerging markets will be substantially more volatile and substantially less liquid than the bonds of governments located in more developed foreign markets.
  • Diversification does not ensure a profit or protect against a loss.
  • Vanguard Total International Bond Index Fund is subject to currency hedging risk, which is the chance that currency hedging transactions may not perfectly offset the fund's foreign currency exposures and may eliminate any chance for a fund to benefit from favorable fluctuations in those currencies. The fund will incur expenses to hedge its currency exposures.
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