Emerging Markets Debt – Not as Risky as You Think

Over the next several years the challenges of collecting sufficient income, due to low current interest rates, may be somewhat lessened by taking a more tactical approach to fixed income investing. Current yield is a big component of investing for income investors and there are opportunities available for investors to achieve attractive current and total returns.

The perception for years has been that emerging markets debt as an asset class had been one of high volatility of returns. But look back to the crash of 2008 and remember that emerging markets experienced less of the effect of the crash and moved out of it faster than the U.S. did.

Looking back at 10-year annualized returns for major markets, the average annual total return for emerging markets debt was over 10 percent, while its standard deviation of returns was less than 10 percent. Contrast that with long-term U.S. Treasuries with had comparable returns but with a standard deviation of about 12 percent and Large Cap Domestic Equities with a 10-year average annual return of less than 5 percent  but a standard deviation of over 15 percent.*

Another factor is that valuations for this asset class remain attractive. A typical valuation metric for bonds is to look at the yield of the security compared to the yield of a U.S. Treasury security with a like maturity date – called the spread. The median spread of high-yield debt over the past 30 years has been about 500 basis points (five percent). Currently, that spread is around 600 basis points. If the economy recovers, during good economic times that spread generally narrows to 300-400 basis point range. This is positive for the price of the bonds.

Many emerging economies benefit from a younger demographic and a fast growing middle class. Also, many of these countries live within their means and have reached a point where they are self-funding.

 Talk to an advisor for detailed information and to see whether adding this asset class to your portfolio makes sense. There are real risks associated with emerging debt, this is not a “set it and forget” it strategy.



CBlakely CFP®, CTFA 05/2012





Source: Morningstar data as of 12/31/2011
Standard deviation is a statistical measure of historical volatility, the higher the standard deviation, the greater the volatility.

Finding Income Without Adding Significant Risk

The current priority at the Federal Reserve is to keep rates low to help the broad economy, especially housing and the money center banks, get healthy again. However, this has a deleterious effect over the long-term on savers and income investors. With short-term interest rates near zero and the Fed committed to keeping rates low for the next couple of years what is an income investor to do? Do you throw out your risk tolerance parameters and plow into stocks?


The short answer is no. You can maintain your risk profile while adapting to the current environment by embracing creative solutions in small percentages in your portfolio. Many solutions used in the past are probably not the solutions that will serve you best over the coming decade. Remember a successful portfolio funds an investor’s current and or future needs or liabilities, anything short of this is a failure.

For high net worth individuals the use of charitable trusts can create a satisfactory income stream. Tax breaks for some charitable trusts can help high net worth investors divest highly appreciated assets tax-free. The trust income goes to the investor and eventually the remainder goes to the charity. For the majority of investors this is not a prudent option.

There are several opportunities for investors not interested in trusts. First, mortgage backed securities funds are an option. These funds contain AAA/Aaa rated mortgage securities backed by the guarantee of Fannie Mae, Freddie Mac and Ginnie Mae. There are many low cost funds available that offer access to mortgage backed securities. The yields are in the 4.0 to 4.5 percent range.

Next, income investors might consider adding a small percentage of high dividend equities to the portfolio. One example might be adding a select dividend fund or a utility fund to your portfolio for the current income. Both types of funds offer a current dividend yield of 3.5 to 4.0 percent depending on the fund family and fund makeup.

Finally, the fundamentals within the high-yield bond market are strong. That is reflected in yields which are currently around 6.5 percent and approaching historical lows. The main risk to the health of corporate fundamentals would be a meaningful slowdown in the U.S. economy. Base case is that the economy does not come off the rails. The most probable economic outlook is for a slow-growth environment with reasonably steady interest rates. However, the economy is not robust enough, nor are yields high enough, to protect high-yield investors against certain macroeconomic shocks. Macroeconomic driven events - such as, the European debt situation, China's slowing economy, and geopolitical events in other parts of the world - will cause short-term gyrations in the funds value.


If your portfolio is predominately fixed income, adding a small percentage in each of the three types of income investments to your portfolio may actually decrease the overall risk profile through diversification. Minor adjustments can add value to your portfolio.

As always, to see the impact this strategy would have on your investments and cash flow discuss this with your (accredited) financial advisor.

CBlakely CFP®, CTFA, CMFC     05/2012

Sources: Morningstar, iShares