[ychart ticker="EMLC" compareto="IEI" calc="price" zoom="all" format="real"]
The risk trade has pushed U.S. Treasury bonds higher and that's made funds holding the near zero interest rate U.S. government bonds actually outperform the much higher yielding government and corporate bonds in the emerging markets. Since the beginning of the second quarter, U.S. Treasury bond funds have been money makers despite the fact that the underlying securities in the fund yield under 3% annually.
The iShares 3-7Yr UST (IEI) exchange traded fund is up 6.68% while the Market Vectors Emerging Markets Local Currency (EMLC) bond ETF is up just 1.62%. Investors who were sold the high yield, good credit story for emerging markets are getting the short end of the stick. The uber safe haven, by comparison, is doing better than equities.
It doesn't matter that the underlying securities in EMLC are all high yielding instruments like Brazilian debt that yields 12.5%, or Chilean debt that yields around 5%. What matters are the bond prices, and the subsequent weakening of the foreign currencies as demand for U.S. Treasurys increased just prior to the end of QE2 and the beginning of the Washington novella known as the debt debate. Mutual fund managers have done better than the ETFs, but not better than IEI. The Goldman Sachs Emerging Markets Debt (GSDIX) fund is up 4.87%, while IEI is nearly 7%. U.S. debt funds are looking like high beta emerging market equities; even better! Over the last 12 months, IEI is up 3.16% while the iShares MSCI Emerging Markets index (EEM) ETF is up just 1.24%.
Why are emerging market high yielding bonds doing worse than low yielding U.S. Treasurys? And why are investors still buying bonds that yield next to nothing?
"The problem with these funds is that the net asset value isn't based on the bond yield, it's based on the bond prices and we have seen more demand for U.S. bond prices in the current flight to safety. So ironically, you did better in U.S. Treasury bond ETFs than you would have done in the higher yielding EMLC," says Ed Lopez, product manager of the Market Vectors Emerging Markets Local Currrency bond ETF.
There is also the problem of weaker emerging market currencies as a result of the safe haven play. When flows left equities and came into U.S. fixed income over the last several months, more demand for the dollar pushed currencies like the Brazilian real and Mexican peso lower. So if investors put $10,000 in a Brazilian bond at a time when the Brazilian real was trading at a strong R$1.55, they ended up investing R$15,500 in Brazilian debt. But if the real weakens to R$1.60, that R$15,500 is not worth $10,000 anymore; it is worth $9,687 instead. Actively traded funds end up losing on the forex.
"USTs have rallied insanely, if a bond (yield) drops several hundred basis points, its capital gain is huge. A high yielding bond whose yield doesn't plummet takes longer to achieve the same total return," says Sara Zervos, who manages over $14 billion in international debt at Oppenheimer Funds.
"Our emerging market bond fund (OEMAX) has emerging market bonds which are higher yielding than Treasurys, but have not had the same capital gain as US bonds," she says. In addition, funds like Zervos' also hold dollar-denominated emerging market debt, whose spreads over Treasurys are historically tight, meaning their interest payment, or yield, is better than USTs, but not much better.
Over a year or more, forex is typically stable to appreciating in countries like Brazil, Chile, China, and Russia, to name a few. Investors need the local currency debt exposure to get the high yield. It's a class case of risk and reward. If investors buy the Brazilian dollar bonds, yields are around 4% compared to 12.5% for local currency bonds. In times of risk aversion, investors flock to the U.S. dollar, driving up Treasury bond prices, and driving up the NAVs of funds like BlackRock's 3-7yr U.S. Treasury debt ETF.
"We've been holding both the local currency and the U.S. dollar-denominated sovereign bond ETFs of the big emerging markets and have been sorely disappointed in both," says Paul Simon, chief investment officer of Birmingham, Mich. based Tactical Assset Management, a $1.5 billion private wealth manager. "I think the bond rally will be short lived. There is still an old school view on the emerging markets that if the U.S. gets a cold, then emerging markets get the flu. That's not the case anymore. The credit outlooks in the big emerging markets are better than the U.S. and Europe. A lot of European money markets are still flowing into Treasurys now, too, so that lends support to higher U.S. bond prices. That is where the short-term money is going and as long as there is a fear trade in play like there is now, there's no way the emerging market is going to catch a bid ahead of the U.S.," Simon says about bond bid and offer prices in the market.
More importantly, however, is the fact that some really big money is at work in favor of U.S. Treasury bonds. Emerging market Central Banks and sovereign wealth funds from Saudi Arabia to China are all big buyers of U.S. Treasurys, driving up bond prices and helping IEI beat EMLC, GSDIX and OEMAX handedly over the last 12 months. Anyone Main Street investor with an E-Trade account thinking that it makes no sense that a fund holding low yielding securities can still clobber a fund holding higher yielding securities need only to consider the political demand around the world for U.S. debt. Invstors are actually willing to pay a premium to lose money. Five year Treasury TIPS were sold last week with a negative real return.
The U.S. Treasury trade, therefore, has become one-sided, warns James Booth of Ashmore Group, a $65 billion asset management firm in London.
"Treasurys are an investment with a very homongenized investment base. If you have a market where it looks like the investor base is similar, it's a warning. The U.S. Treasury market is now completely dominated by the Central Banks. Internally, the Fed can buy more, but if there is no forced demand, then the dollar will collapse; bond prices will collapse. People have not yet factored in a shift away from the dollar again. It's going to happen. Emerging market debt is less volatile than it used to be. The reason you used to invest in EM debt was for beta," Booth says. "Now you invest there because it is the prudent place to be."
Money managers interviewed by Forbes seem convinced that once the institutional investors, generally underweight emerging market debt at the moment, get over the immediate panic that's been in the market since the Aug. 5 downgrade of the U.S. credit rating by Standard & Poor's, they will start reallocating to emerging market bonds again once they grow tired of zero interest rates.
Market Vectors launched the emerging market bond fund on July 22, 2010. Since then, its up 11.4% while the iShares 3-7yr U.S. Treasury ETF is up 6.2%. That's not a very big upside for the currency risk. Year-to-date, the total return on EMLC is 5.46% versus IEI gains of 6.58%.
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