Larry Swedroe, research director at Buckingham Asset Management in St. Louis, has suggested that including emerging market bonds (EMBs) within the fixed income allocation of a portfolio is like tucking sticks of TNT inside it. Although Swedroe is exaggerating to some extent, let’s take a look at a couple of portfolios to understand why his comment does in fact make sense.
This is a typical balanced portfolio that does not include an allocation to EMBs. From 1994 to 2011, it had an annualized return of 6.94%, a standard deviation of 8.06%, and a Sharpe ratio of 0.45.
EMBs Included in the Fixed Income Allocation
By underweighting investment grade fixed income by 5%, and allocating the same amount to EMBs, the annualized return increased to 7.02%. The standard deviation of the portfolio also increased to 8.30%, resulting in lower risk-adjusted returns of 0.44.
EMBs Included in the Equity Allocation
If we replaced emerging market equities (EMEs) with EMBs, the annualized return would have increased to 7.07%. The standard deviation of the portfolio would have decreased to 7.61%, while the risk-adjusted returns would have increased to 0.49. It is important to note that EMBs outperformed emerging market equities by about 4.57% during the measurement period – this type of outperformance would not be expected going forward.
Asset Location – for those considering including emerging market bonds in their portfolio, they should be held in your tax-deferred account (in order to avoid the negative after-tax effects of holding premium bonds in your taxable accounts)
Foreign Withholding Taxes in Tax-Deferred Accounts – By holding a Canadian domiciled ETF, which holds a U.S. domiciled ETF (such as the iShares J.P. Morgan USD Emerging Markets Bond Index Fund (CAD-Hedged) (XEB)) in your tax-deferred account, foreign withholding taxes of 15% will be lost forever. With a coupon of 6.58%, approximately 0.99% (6.58% × 15%) of your return will be lost to foreign withholding taxes.
Note: If you invest in a Canadian domiciled ETF that holds a basket of emerging market bonds directly, you can avoid these foreign withholding taxes. An example would be the BMO Emerging Markets Bond Hedged to CAD Index ETF (ZEF). You could also hold an un-hedged U.S. domiciled ETF in your tax-deferred account, such as the iShares J.P. Morgan USD Emerging Markets Bond Fund (EMB), in order to avoid foreign withholding taxes.
Tracking Error – the actual performance of an emerging market bond ETF can lag the performance of the underlying index by more than the expense ratio (this may be caused by other factors, such as additional trading expenses due to a lack of liquidity). Over the past 3 years, the iShares J.P. Morgan USD Emerging Markets Bond Fund (EMB) has lagged its underlying index by an additional 31 basis points.
Future Expected Returns – our best estimate of the expected return on an emerging market bond ETF is its average yield-to-maturity (YTM) minus estimated foreign withholding taxes minus the estimated management expense ratio (MER). For example, the iShares J.P. Morgan USD Emerging Markets Bond Index Fund (CAD-Hedged) (XEB) currently has an average yield-to-maturity of 3.95%, estimated foreign withholding taxes of about 0.99%, and estimated MER of 0.77%, resulting in an expected return of 2.19% (before-tax). An investor could instead purchase a less risky 5-year GIC and earn about 2.50% (before-tax). Whether or not an investor feels that the risk of investing in emerging market bonds has been adequately compensated for with this low yield is at their discretion.
As it currently stands, I would not recommend emerging market bonds for most investors. If you decide to allocate a portion of your portfolio to this asset class, ensure that you include it in the equity portion (preferably the emerging markets portion) of your portfolio (not the fixed income). Also ensure that you hold it in a tax-deferred account and use the most tax-efficient ETF.