The risk/reward trade off – understanding emerging market debt

The desire to earn the highest possible return from your investments is easily understood. But the level of risk a particular investment or portfolio of investments presents is perhaps less straightforward, although equally important.

One asset may be demonstrably more risky than another. Simplistically, let’s compare holding shares in a very small company to a bond issued by the US government. It is much more difficult to forecast how the shares will perform – their price may soar, crash or stay roughly the same, depending on any number of factors. The return from the bond is more predictable. Usually, the bond will provide the investor with a set regular income, and the amount originally invested will be returned after a defined period, because it is very unlikely that the US government will default on its debt. Theoretically, the shares should be the ‘cheaper’ of the two investments to buy because there is a higher chance that the investor will lose money.

This is called the risk-reward trade-off. Investors expect the opportunity to earn higher returns as a reward for taking on more risk. Whether they choose to do so depends entirely on their current circumstances and their ability or willingness to tolerate that level of risk. Managers of diversified portfolios will also have their own risk parameters (or risk budget) to invest within.

The current environment

Currently, traditional asset classes look expensive. Several major equity markets, including the US and the UK, are hovering around their all-time highs. But compared to their potential earnings, US share prices look very expensive with little value for investors. Meanwhile, yields on government bonds in developed markets are still hovering close to record lows, making them seem unattractive given the prospects of higher inflation and rising interest rates.

Unsurprisingly then, investors are looking further afield for attractive returns. Emerging market debt (EMD), or bonds issued by governments in emerging countries, is becoming an increasingly well-established way to add diversification. The trend reflects EMD’s historically low correlation – the degree by which two investments move in parallel with each other – to the performance of developed market government bonds. The past year has been uncomfortable for emerging markets, due to trade war rhetoric, higher US interest rates, a strong dollar and crises in Turkey and Argentina. But we still expect strong growth for EMD, driven by Chinese and Indian government bonds.

China’s appeal

China is a good risk diversifier in a period of rising interest rates. The country’s US$11.4 trillion1 bond market is considerable in size with demand driven primarily by domestic investors. Therefore, it has historically been less correlated to other emerging and developed market bonds, providing potentially good diversification benefits for international investors, particularly amid global market shocks.

With talk of a trade war with the US and the falling value of the renminbi, bond yields in China, although no longer as attractive as at the start of 2018, are holding up well. The yield on Germany’s most popular bond was 0.47% at the end of September; that on its Chinese equivalent was 3.65%. Both China’s Ministry of Finance and its central bank have revealed policies that intend to support economic growth, among these are more active government spending plans and more lenient lending. On balance, we think there is scope for Chinese government bond demand to increase.

Diversifying into India

Like their Chinese counterparts, Indian bonds are a good diversifier owing to their relatively low correlation with other global bond markets. Again, the economy and bond market are domestically oriented. Indeed, controls on foreign ownership have kept India from being included in most global benchmarks. It may come as a surprise, then to learn that India is Asia’s second-largest bond market, with assets near US$1.5 trillion2, with yields currently around 8%.

Meanwhile, the Indian economy is developing rapidly — it is expected to grow at a rate of 7.3% this year and 7.5% in 20193.

Despite having implemented guidelines for controlling inflation (the rate at which the prices of goods and services increase), the Reserve Bank of India (RBI) has not relaxed interest rates, even though inflation fell to 1.5% in June 2017. Responding proactively to increasing oil prices, and other factors that are likely to cause inflation to rise, the central bank raised the main interest rate to 6.25% in June and to 6.5% in August. Higher interest rates mean that consumers are more likely to save their money than spend it, reducing demand for goods and services and slowing inflation.

The RBI also continues to pursue wide-ranging financial-market reforms, including efforts to improve corporate accounting practices, and reducing the incidence of fraud. It may be a few years before we see the full outcome of these reforms, but in time, they should combine to support investor confidence in India and reduce the level of risk associated with investing there, further increasing its attractiveness as a place to invest.

Dare to diversify

Investors should always buy diversifying assets on merit, not just because they are different. But as outlined above, asset classes such as EMD (particularly Chinese and Indian government bonds) can provide the potential to increase returns and reduce risk, while offering a low correlation to more mainstream assets.

1China – debt securities issues and amounts outstanding’, Bank of International Settlement, Q4 2017

2‘India’s debt markets: the way forward’, pg 11, Asia Securities Industry and Financial Markets Association, July 2017

3Global Economic Prospects: the turning of the tide?’, World Bank Group, June 2018

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