Better yield, higher risk

It’s easy to understand the appeal of emerging-markets bonds. With the DEX universe bond index in Canada yielding 2.7% as of Oct. 31, the 5.6% yield of emerging-markets bonds – as measured by the J.P. Morgan EMBI global diversified index C$-hedged (JPMEMBI) – is attractive. However, financial advisors need to look beyond yield to assess the risk characteristics of this asset class before including it in clients’ portfolios.

Although emerging-markets bonds offer the potential for higher returns and provide a diversification effect relative to Canadian bonds of similar credit quality, the much higher volatility and drawdowns for emerging-markets bonds significantly limits their role in a portfolio.

This higher risk was on display recently as the prospect of the U.S. Federal Reserve Board’s tapering of its monetary stimulus program triggered a tightening of financial conditions and precipitated a sharp sell-off in emerging-markets bonds. The JPMEMBI fell by 8.4% over the months of May and June. In contrast, the DEX hybrid bond index, which has a similar mix of investment- and speculative-grade bonds and only a modestly lower duration, fell by 3%.

The higher drawdown for the JPMEMBI reflects several unique aspects of that index. First, although hedged to the Canadian dollar, the underlying bonds are denominated in U.S. dollars (US$) and are exposed to U.S. monetary policy and interest rate risk. While Canadian bonds are not immune to Fed policy, the impact is more muted.

Second, emerging-markets bonds are only a small component of the global bond market. According to Barclays Capital Inc., the Barclays emerging-markets US$ aggregate bond index had a market capitalization of US$2.7 trillion as of Dec. 31, 2012. This comprised only 6.2% of the global bond market of US$43.2 trillion, as measured by the Barclays global aggregate bond index. Hence, liquidity for emerging-markets bonds can dry up quickly in response to either policy changes or negative fundamentals that can precipitate a run-up in interest rates and sharp price declines.

Since January 2003, based on monthend returns, the JPMEMBI has suffered three drawdowns in excess of 5%, with the most significant being a staggering decline of 24% from May to October in 2008. In contrast, the Bank of America Merrill Lynch Canadian corporate BBB index (BofAML) has had only one decline in excess of 5%, having dropped by 5.4% from August through October 2008.

The Canadian resources and energy sectors are subject to many of the global swings that affect emerging-markets bonds. As a result, the JPMEMBI has had a much higher correlation to Canadian equities than Canadian bonds of similar credit quality. From January 2003 to October 2013, the JPMEMBI had a 0.54 correlation with the S&P/TSX composite index, compared with the 0.22 correlation of the BofAML. This higher correlation substantially reduces the diversification utility of emerging-markets bonds in portfolios that contain Canadian stocks and lower-grade corporate bonds.

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The firm, its principals, employees and clients may own securities mentioned in this article.