There are many voices online and in the investment world that encourage people to invest and claim they can show them how. Many of these are well intentioned and aim to increase knowledge of markets and personal finance, as well as taking your financial future into your own hands. Many of these are good and well intentioned practitioners. They seek to help people overcome the initial fears and daunting amount of knowledge it may take to start investing by making investing more relatively to their daily lives.
Yet what’s also important in these times of bull markets, is that once you do have the basics of discipline and investing down, return, risk and time are the most important factors in regards to growing your hard enseñes savings over time. These factors, as boring as it is, are achieved by diversification. Many of us are drawn to the momentum of recently well performing stocks like Microsoft and Apple but if someone were to tell you that you have to buy a stock that you couldn’t sell for 50 years, would you still buy these stocks or would you buy an index which will always contain the winners? Yes there are stocks that have survived this long and thrived, but picking them and seeing outsized returns for 40 years, especially when millions of others are trying to do it is very unlikely to happen. Many of the people who got rich off of Enron and GE stock in the late 90’s and early 2000’s thought they bet on the right horse, but life is long and the top of the mountain almost never has the same companies on it.
There are also a number of voices espousing a more simple approach, to just invest in index funds precisely for the reasons I mentioned above. Over time, a simple market capitalization weighted index like the S&P 500 has beaten managed equity returns over periods greater than 15 years. If you are a betting person, it makes more sense to go with the index over time.
Bond Indexes and Active Management
With so much focus on equities, probably because they offer the largest and often quicker returns, along with the greatest risk, advice on bonds tends to get drowned out. Many assume that the index logic applies to fixed income just as it does for equities but this isn’t necessarily the case.
A market capitalization weighted equity index rewards investors as companies increase their profits. This means that the value of their shares grow with the profits and they take up a larger and larger portion of the index. This means that the equity indexes are typically made up of the winners: those are either the highly profitable companies (like Apple) or the companies that the market thinks will be highly profitable in the future (like Tesla). This is not the case for bonds though.
A bond index is a representative sample of the universe of bonds that are available at any one time. Since companies and countries have different debt needs at different times, indexes may shift in their composition and this means the largest debt issuers will get a larger portion of the index, which means they don’t have to be profitable, just issuing a lot of debt. For example, the Bloomberg Barclays 1-10 year Corporate Debt index has Bank of America, CVS and T-Mobile as it’s largest constituents, not exactly the most profitable companies when compared to the stock market winners.
This can lead to concentration of certain industries or countries which are not as healthy or highly leveraged into the index. A bond fund manager has the advantage of being able to reduce exposure to these overrepresented borrowers in an index to avoid potential defaults and enhance returns. So the case for bond index funds is not as strong or straightforward of a case as it is for equities.
The Case for International and Emerging Market Bonds
That being said, just like equities, bond returns can also benefit from diversification and here is where American and most rich world investors may be losing out by following the conventional wisdom of holding government bonds and stocks in their portfolio. A typical 401(k) investor who knows they should invest but doesn’t monitor their investments closely, may be auto enrolled into a diversified target date fund like those offered from Vanguard. These funds use modern portfolio theory to adjust over the investor’s lifetime away from equities and towards more bonds.
What are those bond investments actually? When rates were high and less than half the world issued capital market debt, it made sense to invest in the safe asset of US government debt. The reality since the financial crisis has been that the US and rich country bonds have been mired in an environment of secular low rates which depend on price appreciation for much of their return. At the same time, most countries around the world have embraced the global capital markets in some form or another as a means to raise debt, build infrastructure and fund programs for their citizens. Yet due to the fact that the GDP’s of large economies are so much greater, they are also able to issue a much greater amount of debt, crowding out the debt of emerging countries. This is reflected in both the Vanguard Total Market Bond Fund, which is domestically focused with 43% being made up of low yielding Treasury Bonds….
…as well as with the international bond index, which is more European, low rate country heavy.
According to data collected by an NYU professor since 1928 in the US, stocks have returned 9.8% annually while bonds have returned 4.9% annually. In the last 10 years however, US government bonds have returned 4.6% as opposed to the return of 7.3% over the period of 1971-2020. The days of high bond returns for US sovereign debt are behind us and we seem to be looking at a future of low rates and low returns.
It’s a similar story in Europe and other developed markets like Japan where low rates have produced weak fixed income returns for investors for periods as long as 20 years. In contrast, Emeging Market debt still offer a more reasonable return outlook. In a great post on the website monevator, the authors make a case for emerging market bonds as a part of your growth portfolio based upon the risk adjusted returns they have offered over the past few decades. They contend that emerging market USD sovereign bonds have offered some of the highest risk adjusted returns of any investment class including shares of the S&P 500 and ironically, emerging market shares themselves.
Below you can see the visual in GBP of how emerging market sovereign bonds performed versus equity since the crisis.
You may be thinking that they cherry picked the data period above, the bad returns of emerging market equity since 2008 and including the good times for EM debt during the period 2002-2008, so the post also referenced a calculation done by the online community Bogleheads which looked all the way back to the 90’s which included turbulent times for emerging market debt including the Asian Crisis as well as the Tequila Crisis for Mexico yet found similar results.
The volatility versus the return above is enough to give anyone pause when it comes to emerging market equity and ask if their risk justifies the return. In contrast however, there looks to be a valid case for including emerging market debt in your portfolio given an 8.8% annualized return versus volatility of 12.9%.
EM debt has not been immune to the low rate environment though and returns as of late have also not matched their historical precedent. Over the last 5 years funds like the iShares USD Emerging Markets Bond ETF have offered a return of 4.25%, lower than the historical 8.8% featured above but 107% higher than the 2.05% US Treasury Bond ETF return over the same period.
A number of EM countries are currently raising rates aggressively, in contrast to the expectation that rates in the US will remain flat for much of the next year. That has the dual effect of not only offering more yield for new investors to these markets but also appreciating currency for those willing to invest in local currency bonds. With low rates dominating fixed income portfolios for rich world investors, they would do well to diversify further and actively into the three main asset classes that fall within emerging market debt, USD sovereign bonds, local currency sovereign bonds and corporate bonds. The practice of the “set it and forget it” funds may take into account global diversification of equity but has yet to deal with the issue of an outsized pool of low yielding fixed income debt that fixed income investors may not find as attractive if they are looking at risk versus return.
As discussed above, investors may also benefit more in this sector through active management. I am not recommending a particular fund here but hope to provide overviews of funds in a future post. Emerging market shares continue to disappoint but it doesn’t mean investors should write off all of them, there is still value to be found in their bonds.
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