We have argued for some time that emerging market (EM) hard-currency bonds, particularly those issued by sovereigns, have been one of the best performing fixed income asset classes globally over the last 15 years. In EM USD sovereign bonds: Strategically desirable, tactically attractive , we showed that the asset class has exhibited an information ratio (annualized returns divided by annualized volatility) of close to 1 over this time horizon, outperforming many comparable developed market fixed income segments in terms of both total and risk-adjusted returns.
A fascinating recent NBER paper titled Sovereign Bonds since Waterloo by Josefin Meyer, Carmen M. Reinhart, and Christoph Trebesch has taken the historical analysis of the asset class's performance a whopping 185 years further back. The authors built a time series of monthly prices for 1,400 emerging market foreign-currency bonds since the battle of Waterloo in 1815, spanning 91 countries—a database of more than 200,000 observations.
The authors conclude that notwithstanding defaults, wars, and global crises, the average real yearly return on a global portfolio of hard-currency emerging market sovereign bonds was 6.8% over the entire sample, about 4% higher than that of “risk-free” benchmark government bonds of the UK or the US. The lion's share of those returns is explained by coupon payments (70%) rather than by price changes (30%). Such diversified exposure to hard currency emerging market sovereign bonds has shown favorable risk-return properties compared to other assets during in the last 200 years (see Fig. 1 below, or Fig. 12 in the paper). Only US equities show a higher average return, but these also have a higher standard deviation.
Asset classes across 200 years: risk and return
In Thinking strategically about emerging markets, we demonstrated that in addition to possessing desirable stand-alone risk-return properties USD-denominated bonds in emerging markets have historically added great diversification benefits to global portfolios, leading to improved risk-adjusted returns of the overall portfolio (see the exercise presented on Fig. 41 of the report).
We have also argued in The case for EM hard-currency bonds that defaults of EM sovereigns have been a common occurrence in the past, and will almost certainly continue to occur in the future, but that it's important to separate the individual stories from the asset class as a whole. Interestingly, the NBER paper also conducts a census of all distressed sovereign debt restructurings since 1815. Their sample includes a total of 313 external sovereign debt restructurings in the last 200 years. As painful as many of these credit events have been, the authors argue that investors have been compensated for the risks involved. Looking at the behavior of a group of 60 “serial defaulters,” they conclude bonds from these issuers provided on aggregate significantly higher returns compared to UK or US government bonds as well as in comparison to emerging market countries that have never defaulted, in addition of course to a higher standard deviation of returns.
All in all, we conclude that 200 years of EM bond history support our thesis that emerging market USD-denominated bonds should constitute an integral part of globally diversified portfolios. For those under-allocated to the asset class, we continue to recommend looking past the idiosyncratic noise in emerging markets and rebalancing in favor of this great source of risk adjusted returns.
Alejo Czerwonko, Emerging Markets Strategist Americas, UBS Financial Services Inc. (UBS FS)