Fourth, expansion of middle classes across many emerging markets is promoting more stable economies that can better withstand foreign shocks. Daniel Arbess, who manages the $2.1 billion Perella Weinberg Partners Xerion Fund, which has delivered 18% annualized returns since starting up in 2003, believes this is a key driver that is shifting global growth from the west to the east.
Net inflows into emerging market debt are on pace to set a record this year, potentially topping $70 billion, 40% higher than last year, according to Christopher Dillon, fixed-income portfolio specialist at T. Rowe Price. He believes U.S. and European mutual funds, with an increasing boost from Japan, are pushing this flow.
Two sovereigns representative of emerging market bond opportunities include an "A"-rated Mexican state bond, with a coupon of 8.5%. Maturing at the end of 2015, the bond was yielding 7.2% at the end of October, with a yield to maturity of 5.71%. A "Baa3"-rated Brazilian sovereign, due in the beginning of 2015, has a current yield of 10.4% and a yield to maturity of 11.64%. In contrast, the five-year U.S. Treasury bond is yielding 1.69%.
Dillon surmises demand will receive a lift from U.S. pensions. With assets of $16 trillion, and looking to return 8% a year, says Dillon, "pension managers will likely boost their current negligible allocation to emerging market debt to between 3% and 6% due to the lack of compelling income alternatives." Expect a similar shift from European and Asian pensions as well.
Developed Markets
Though limited, a few developed markets offer attractive yields. In late October, an "AAA"-rated Australian sovereign, due in April 2015, is currently yielding 6%, with a yield to maturity of 5%. Investors can gather up to an additional 100 basis points by venturing to Australian state (e.g., Queensland) and corporate bonds.
What makes these bonds especially attractive is exposure to the Australian dollar. Many analysts believe long term the currency should continue to appreciate given the strength of Australian economy, significant commodity wealth and exports to China, and the U.S. dollar's weak outlook. (See our story on Australia in August 2010 issue.)
While concerns about European debt and the euro sent yields climbing in troubled peripheral markets this past summer, Oppenheimer's Sara Zervos believes the response of local governments and the European Central Bank has significantly reduced the likelihood of debt restructuring in places like Spain, Italy, Portugal and Ireland. While spreads over Treasuries have come down from the height of the panic, investors can still collect 5% on three-year Irish sovereigns.
If Zervos' call is correct, attractive yields will be boosted by subsequent credit improvement and bond appreciation. But continued sluggish economic growth could hamper fiscal recovery. According to a recent forecast by the Economist Intelligence Unit, growth across the eurozone over the next several years is projected to be no more than 1.5%.
Mutual Funds
Buying individual bonds offers transparency. Investors know the cost, risk, and yield, and there are no annual expenses. In case of a sell-off, they can wait until maturity to realize full value. And if exchange rates are undesirable when a bond matures, investors can roll over proceeds into another bond and wait until rates improve before repatriating the currency back into dollars.
But most advisors use mutual funds to navigate global debt markets. They offer access to foreign debt through three types of offerings that invest in government, corporate, and supranational (e.g., World Bank) debt. Bonds are issued in local, dollar- and euro-denominated currencies. And issuers can be local firms or multi-nationals looking to finance local operations.