Lessons from two centuries of EM bonds

Thought of the day

by Chief Investment Office 08 Apr 2019

Emerging market (EM) hard-currency bonds have been one of the best-performing fixed income asset classes globally over the last 15 years, with sovereign issuance in particular showing value. EM bonds’ information ratio, which weighs annualized returns against annualized volatility, has outperformed many comparable developed market fixed income segments in terms of both total and risk-adjusted returns.

A recent NBER paper extends this historical analysis a further 185 years back, with a unique data set that spans 91 countries and includes monthly prices for 1,400 EM foreign-currency bonds since the battle of Waterloo in 1815. Notwithstanding defaults, wars, and global crises, the NBER paper finds that the average real yearly return on a global portfolio of hard-currency EM sovereign bonds was 6.8% over the entire sample. That’s about 4% higher than that of “risk-free” benchmark government bonds of the UK or the US. 70% of this return is chalked up to coupon payments, with the remainder due to price changes.

On top of that, diversified USD-denominated EM sovereign bonds have shown promising risk-return properties compared to other assets over the last two centuries. Only US equities show a higher average return, with the caveat that they did so with a higher standard deviation. This lines up with our previous analysis backing the promise of diversification, with global portfolios that include USD-denominated EM bonds showing better risk-adjusted returns.

And what of EM sovereign defaults? We agree they have been relatively common in the past and will likely continue to occur in the future. But the NBER paper also examines 313 such episodes and finds that investors have been compensated for the risks involved. The study found a group of 60 “serial defaulters” 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. The group naturally has a higher standard deviation of returns, too.

So we think the last two centuries of EM bond history back our view that investors should set aside idiosyncratic noise and continue to integrate EM USD-denominated bonds as part of their globally diversified portfolios.

A more detailed version of this piece, “What can we learn from 200 years of emerging market bond history?” is available as part of our blog series.

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