Emerging Market Sovereign Bonds; Safe Haven or High Yield in Disguise (EMB, ELD, LQD, HYG, IEF)

With American, British, German, Japanese and other ‘safe haven' sovereign bonds yielding 2% or less many fixed income investors are looking for an alternative to increase cash flow yield in their portfolios. Investors must be VERY careful however, in making sure they are supplementing cash flow without increasing risk. Emerging Market bonds are one asset class being used as a ‘safe haven substitute', but is this appropriate? Most investors realize if they replace ‘safe haven' treasury bonds with high yield (or junk) bonds they are gaining a large income advantage (recently the spread was around 6%) but also are increasing risk substantially. When buying junk bonds (from a correlation point of view) you are essentially purchasing lower volatility/higher yielding equities, but equities none-the-less. Even though in form these are indeed bonds, for the most part they trade right along with stocks, just with less volatility. Therefore replacing treasuries with a high yield bond ETF like iShares High Yield Corporate

is not appropriate for most risk conscious investors. Year to date 2011 where ‘safe haven' bonds, proxied by the iShares 7-10 year treasury ETF

are up around 15.3%, HYG is right around break even while providing little to no hedging benefit. Investment grade corporate bonds, proxied by the iShares Investment Grade Corporate ETF

are a much better ‘treasury' substitute, though not perfect. The current interest rate spread advantage is around 2%, and you are purchasing bonds that for the vast majority of the time react to interest rate risk vs. credit risk (the same as treasuries). Although investment grade bonds are not a perfect hedge for equities they tend to be much more correlated with treasuries than stocks. One notable exception was the second half of 2008 and to a much lesser extent 2011. Although Investment grade bonds are up around 5%-6% on the year, this is much less than comparable treasuries. A relative new comer to a lot of investor's portfolios are the aforementioned Emerging Market Sovereign bonds. These have increased substantially in popularity over the past couple years. The questions to ask however are; what purpose do they serve in a portfolio and on what side of the risk spectrum do they fall? Historically (which probably gives good insight on how the will ultimately behave) emerging market sovereign bonds have been highly correlated with equities and high yield bonds. They are risk assets and trade over the longer term as such. For a much more detailed explanation I would recommend the book ‘This Time is Different' by Carmen Reinhart where detailed analysis of historical emerging market bonds returns and mass defaults are highlighted. More recently, emerging market debt; proxied by the iShares Emerging Market Bond ETF

has traded on both sides of the risk spectrum. The period from July 26 through the end of August saw the SP500 lose 9%, high yield lose 5%, while emerging debt inched up just less than 1%. This was right in line with investment grade debt, so although not providing a large hedge advantage against equities, emerging bonds did not add to losses. However fortunes and correlations reversed from the end of August through October 4th (recent market low). During this period emerging markets were down almost 7%, trading almost exactly in line with high yield bonds and equities. Investment grade (which is a more reliable ‘safe haven' play) was unchanged for the period. This is an asset class (along with gold) that switches between ‘safe haven' and ‘risk-on'. This fact and the historical evidence pointing to an asset class that traditionally is a ‘risk-on' investment leads Traphagen Financial Group (www.tfgllc.com) to believe it is not a suitable ‘safe haven' substitute despite the 3% yield advantage over treasuries. Emerging market debt can however, be a useful piece of an investors' overall emerging market exposure as an emerging equity substitute as long as the risk is understood. As an aside, Traphagen views local currency denominated emerging debt riskier than US denominated bonds and unless the investor is convinced the US Dollar will fall in relation to emerging currencies, most US investors would be better served investing in US dollar pegged debt (this is especially true for risk sensitive investors looking mainly for yield). This ‘added risk' can be seen in comparing the WisdomTree Emerging Market Local Debt Fund

and EMB. Year to date as most emerging market currencies have lost value compared with the dollar ELD is down around 2% while EMB is up around 4.2%. The difference in return (more than 6%) is mainly due to emerging market currency devaluation in comparison to the US Dollar. Earlier this month our firm has cut exposure to the asset class on strength, and will hold off on increasing exposure until there is more finality on the European debt crisis. For more information on our portfolios, investment philosophy, and links to archived quarterly investment newsletters please visit www.tfgllc.com.