Luz Padilla remembers a conference call in the late 1990s promoting a new issue of Indonesian corporate bonds as a very tiring event that took place in the wee hours of the morning and drew just three participants.
A follower of emerging market bonds since she began her career in the mid-1990s, the manager of the DoubleLine Emerging Markets Fixed Income Fund has seen the category blossom from a niche investment into a much-followed corner of the market. "Now, there can be hundreds of people listening in on an emerging market bond conference call," she says. "And thankfully, they take place during normal business hours."
Over a decade after Padilla's lonely encounter with Indonesia bond analysts, the world of emerging market bonds has undergone a complete facelift as emerging market countries and companies shake off their frontier image and gain new respectability. Once hotbeds for political unrest and rampant inflation, countries such as Brazil and Peru have taken steps to control those demons through government and banking reform, and investors have taken notice. Emerging market bond funds now have $186 billion in assets, and saw $54 billion in inflows during 2010 and over $14.8 billion so far this year, according to the EPFR Report.
In exchange for taking on emerging market risk, investors have enjoyed superior returns compared with most other types of fixed-income investments and even many stock markets. Over the last ten years, the Merrill Lynch EM Sovereign Index has achieved an annualized return of 11.03%, compared to 5.52% for U.S. Treasurys, 8.6% for U.S. high-yield bonds, and 2.64% for the S&P 500 index. The last year has been a particularly rewarding one for emerging market bond fund investors, who averaged a return of nearly 14%, according to Morningstar.
All this money pouring into emerging market bonds has pushed up prices and driven down yields relative to U.S. Treasury bonds and other developed market securities. Still, the 4.6% average yield on emerging market bond funds beats the 2.76% yield for taxable U.S. investment-grade bond funds tracked by Standard & Poor's by a considerable margin. And Padilla says there's room for appreciation, particularly at the corporate end of the market.
"This asset class will continue to deliver," she says. "Going forward, I believe high-single-digit returns in the corporate emerging market debt are very achievable."
Avoiding Sovereigns, Local Currencies
Recent inflows into emerging market bond funds have been the strongest in the local currency end of the market, which includes sovereign debt issued by local governments as well as corporate securities. Many investors are banking on an appreciation of local currencies against the dollar to increase investment returns.
But in a bold decision to eschew that popular strategy, Padilla has avoided local currency government and corporate bonds since the fund was launched in April 2010 and has focused almost exclusively on dollar-denominated securities. She has done so to skirt local currency risk, which she believes is still a very real threat in emerging markets for a number of reasons.
Inflation and policymaker attempts to control it through tightening interest rates and other measures top her list of concerns. "Inflation is taking hold in many emerging markets, and leaders have been aggressively addressing it, especially in the last 12 months," she says. "That is not good news for local currency bonds."