Some EM Bond Approaches Carry Exposure to Rising US Rates by Paul DeNoon, AllianceBernstein
With concerns about rising rates hitting a fever pitch in the US, investors have turned to emerging-market (EM) bonds to diversify risk. Unfortunately, for some, this has increased their US interest-rate risk—exactly the snake in the grass they were looking to avoid.
EM bonds have understandably attracted investors over the years. With higher growth rates than developed markets, stabilizing economies and attractive yields, the asset class has been a sensible addition to many portfolios.
But after two consecutive years of hard-to-explain returns on a popular EM bond index in 2013 and 2014, we looked under the hood to show investors that some approaches to EM bond investing can increase a risk that investors are trying to avoid.
A Tale of Two Years
In 2013, the J.P. Morgan Emerging Market Bond Index (EMBI) suffered a devastating year, tumbling –6.58%. So which countries were the culprits? None of them. Surprisingly, EM countries weren’t to blame for the index’s downfall in 2013. In fact, despite hurdles for a few countries, it was a largely positive year for many, including Belize (+49%), Argentina (+19%), Ecuador (+15%) and Pakistan (+14%).
In 2014, the situation reversed, and the EMBI made an impressive rebound, returning +5.53% for the year. But the comeback didn’t reflect the economic landscape at the time, which was dominated by the collapse in energy prices, political turmoil and concerns about global growth. Some countries took major hits, including Venezuela (–29%), Ukraine (–30%) and Russia (–10%).
So why the disconnect? Why did the index perform poorly when EM fundamentals were strong (2013) and bounce back when the news was dire (2014)?
The answer is US duration. The EMBI, as a US-dollar–denominated index, had a US duration of 6.98 years, as of June 30, 2015. This is almost 1.5 years longer than the 5.53-year duration for the Barclays Aggregate Bond Index. The longer the duration, the greater an index’s potential for volatility and unpredictability. And the longer its US duration, the greater its specific sensitivity to US interest rates.
In 2013, US bond yields rose significantly, with 10-year US Treasury yields spiking 150 basis points. The amount of duration in the index caused the EMBI to fall considerably. In 2014, US yields fell, so US duration helped make a good year against a poor macroeconomic backdrop for EM investors: the index rose.
Understanding All the Risks
While it’s important to view EM from a bottom-up investment perspective in order to uncover market dislocations and relative-value opportunities, it’s also essential to keep in mind the other risks that can drive returns.
Investors wanting to lighten up on US duration may want to think twice about how they approach that emerging-market investment. In our experience, a dynamic, multi-sector approach to high-income investing offers a more prudent path.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
