Looking for Yield in Emerging Market Bonds (ASX: EBND)

I have finally sold HVST! For many years I have been holding onto this ETF, which has steadily gone down over many years (see The Problem with HVST). The reason why I was so reluctant to sell HVST was because it provided big juicy franked dividends paid monthly. As of today, HVST’s dividend yield is approximately 8 percent. Even though I enjoyed the high dividends, I was disgusted by the capital decline, so I made the decision to sell all my HVST.

Having sold HVST, I had spare cash which I was keen to reinvest. I decided to reinvest a portion of the cash into VanEck Emerging Income Opportunities Active ETF (EBND), an active ETF from Van Eck that invests in emerging market bonds.

What exactly are emerging market bonds? Basically you are lending money to the governments of poor countries. The average person might think this is financially reckless because of the credit risk of these government, but higher credit risk means higher yield. Investing in bonds of developed countries unfortunately means accepting very low yield (sometimes even negative yield). However, because these EM bonds are packaged in an ETF, you get significant diversification. You are not putting all your money into one country. In my opinion, investing in emerging market bonds is no more risky than investing in high dividend Australian equities.

Why invest in EBND?

The main reason I invested in EBND is because I wanted reliable and high monthly passive income. I was getting monthly passive income from HVST of about 8 percent. EBND provides monthly income as well, but its yield is approximately half that of HVST at about 5 percent. This might seem low, but the main benefit of EBND over HVST are capital gains or capital preservation.

EBND (blue) has outperformed HVST (red) during COVID-19

The chart above shows EBND (in blue) outperforming HVST (in red) during the COVID-19 crisis. I sold HVST in July 2020, so I wasn’t able to insulate myself from the COVID-19 crash of March 2020, but EBND would have provided no protection against this downturn anyway. In fact, as the chart above shows, EBND went down even more than HVST did. However, what EBND has been able to do was recover rapidly as central bankers around the world embarked on agressive money printing. In contrast, HVST has languished during the pandemic and continues to go down to this day.

What is surprising from the chart above is is how similar EM bonds are to global equities. The chart below compares EBND (blue) to global equities represented by VDHG (red) compared to DM bonds represented by VBND (green).

EBND (blue) is not a defenstive asset like VBND (green) is. In fact, EBND’s price chart somewhat resembles global equities as represented by VDHG (red).

The chart shows that EM bonds have a somewhat similar risk profile to global equities (with a beta of approximately 0.8). The chart also clearly shows that DM bonds are a much better defensive asset. The March 2020 COVID-19 crash resulted in large declines for EBND and VDHG of about 15 percent to 25 percent respectively but for VBND there were declines of only about 7 percent.

However, because I am still in my thirties and still consider myself somewhat young, I am comfortable taking more risk. Investing in EM bonds exposes me to equity-like risks while still providing high monthly income.

Another reason why I have invested in EBND is to diversify my sources of passive income away from Australian equities. A big problem with relying on Australian equities for income is concentration risk. The ASX 200 is dominated by a handful of banks and miners. If anything happens that significantly affects these businesses, your dividends are under threat. We are seeing this today as Australian banks cut dividends due to the impact of COVID-19. While I still hold a reasonable amount of high dividend Australian equity ETFs (e.g. through IHD and SYI), I am keen to spread my passive income sources to other areas in order to reduce risk. Having sold a large amount of HVST, I am keen not to reinvest the proceeds back into Australian equities which would only exacerbate my concentration risk.

EBND vs IHEB

Those who keenly follow the ASX ETF scene may understand that EBND is not the only EM bond ETF on the ASX. In fact, an investor can invest in EM bonds through the iShares J.P. Morgan USD Emerging Markets Bond (AUD Hedged) ETF (IHEB).

The benefit of IHEB over EBND is that is has a much lower management fee of 0.51% rather than EBND’s pricey 0.95 percent. This is due to the fact that IHEB is a passive index fund vs EBND which is actively managed.

While EBND pays monthly income, IHEB pays income tri-annually. Both seem to have roughly similar yields of about 5 percent, although EBND’s distributions seem more consistent and smooth.

Another major difference between EBND and IHEB comes from currency and particularly the US dollar. IHEB invests only in US dollar denominated bonds. This means it invests in debt from countries that borrow in US dollars. What this means is that if the US dollar goes up in value, the debt of these governments rise. This makes IHEB highly sensitive to the US dollar. IHEB will perform better the weaker the US dollar is. Add to that the fact that IHEB is AUD hedged, which means that as the US dollar weakens, IHEB will go up even more. In contrast, all currency considerations in EBND are at the discretion of the fund managers. The fund manager could invest in US dollar denominated EM bonds, but they can also invest in EM bonds denominated in the country’s local currency.

EBND (blue) vs IHEB (orange) vs DXY (purple)

The chart above shows EBND (blue) vs IHEB (orange) vs the US dollar index DXY (purple). About half of all debt in the world is denominated in US dollars. A considerable amount of investors borrow in US dollars (low yield) and invest in emerging markets where yields and risk are higher. However, borrowing to invest is extremely risky. You amplify your gains but also amplify any losses, which is why many investors who leverage are keen to sell during times of crisis. For example, during e.g. the March 2020 COVID-19 crash, when asset prices were collapsing, many investors sold down assets. They do this either because they wish to sell assets themselves before prices go down even further or perhaps they are forced to sell by their banks as margin calls are triggered. Regardless, because they borrowed in US dollars, when they sell assets, they get US dollars in return, which increases the demand for US dollars. This explains the spike in DXY in purple during the March COVID-19 crash.

As the chart shows, IHEB collapsed as DXY spiked, which makes sense. However, during the COVID-19 recovery, IHEB recovered rapidly as central banks aggressively printed money and devalued the US dollar. EBND is much less senstive to USD currency fluctuations.

The tables below also show that the countries that IHEB invests in (right) seem different to those that EBND (left) invest in. Generally speaking, resource rich countries (e.g. Saudi Arabia, Qatar, UAE, Russia, and Brazil) seem to have more US dollar denominated debt.

Problems with EBND

As mentioned above, high management fees of 0.95% are a big problem with EBND. Over time, these fees will compound, eating away into returns. Another downside for EBND is active management, although some argue that active management is beneficial in emerging markets where human discretion matters more.

The opportunity of emerging markets in general

I am investing in EM bonds for income, but I am also investing more and more into EM equities as well (via IEM). Global macro investor Raoul Pal has recently tweeted a chart of the EM equities to S&P 500 ratio, which suggests that EM equities are highly undervalued and may turn any moment now to the upside.

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EM equities to S&P 500 ratio. Source: Raoul Pal

I also think that many people overestimate the risk of emerging market bonds and emerging markets in general. Most people think of EM countries as backwards and corrupt, places where money cannot be made. But this is simply not true, and the fact that people believe this I think means that EM is undervalued relative to DM, which is bullish for EM.

EM countries have very favourable demographics i.e. higher population growth and a much younger population. They also have a strong appetite for economic growth and development. As a world traveller, I’ve been to many of the “megacities” (urban population > 20 million) of the world today (e.g. Shanghai, Chongqing, Mumbai, Delhi, Sao Paulo, Jakarta, Dhaka, and even Lagos), and when I explore these cities, I get a strong sense of how dynamic these places are and how much pent-up economic growth they hold.

In my opinion, the only downside to emerging market investments are ethical concerns. If you lend to e.g. the Chinese or Indian governments, are you contributing to the oppression of Uighurs in China or Kashmiris in India? There is a question mark on the ESG credentials of these investments. On one hand, developed markets tend to have more political freedoms and e.g. greener policies, but on the other hand, if you don’t invest in emerging markets, they will remain poor, which is not ethical.

Living off Dividends vs the Four Percent Rule – Part 2

According to Wikipedia, financial independence is defined as “the status of having enough income to pay for one’s reasonable living expenses for the rest of one’s life without having to rely on formal employment.”

Financial independence does not mean you have e.g. a late-model luxury car, an expensive house, a nice watch, or even a paid-off house. If you have to work, you’re not financially independent because you are dependent on your job.

So how do you live off your investments forever? There are two main ways to achieve this: (1) live off dividends and (2) sell assets according to the “four percent rule.”

In a post I made back in 2018 titled 4% Safe Withdrawal Rate vs Living off Dividends, I claim that it is better to live off dividends because it is easier:

 [It] is better in my opinion to simply live off your investment income (dividends, rent, interest, etc) as there is no calculation involved and no work. Everything is on autopilot. That being said when living off dividends there is a trade off between income and growth (see The Problem with HVST) and this is where I think the four percent rule can be used as a guide. If your dividend income is more than 4% of your net worth, invest more in growth assets whereas if your dividend income is less than 4% of your net worth, invest in income-producing assets.

Living off dividends is indeed simple. Suppose you have $1 million. You invest it in a high dividend ETF (e.g. IHD, SYI or VHY) and that is it. The dividends will be paid to your bank account, which you live off.

However, there are many problems with relying on dividends. Typically Australian investors have relied on blue chip Australian stocks for dividends because of favourable tax treatment (due to franking credits). The problem is that these stocks tend to be concentrated among a handful of companies and historically Australian high dividend payers have performed poorly. It makes sense that high dividend paying stocks underperform because each dollar paid out in dividends is a dollar not reinvested in the company. Because the company pays out the profit as dividends, it is not able to use that money to further grow the company. The chart below demonstrates the underperformance of high dividend paying stocks by comparing an Australian high dividend ETF (black) with the broader Australian equity market (orange). For the sake of comparison, the Nasdaq 100 is represented in blue, which is the NDQ ETF tracking an index that consists mostly of technology companies that historically pay low dividends but instead reinvest profits for growth. Major companies in NDQ are Amazon, Microsoft, Apple, Google, Facebook, etc.

High dividend ETF IHD (in black) underperforms the broader Australian stock market (represented by STW in orange) and significantly underperforms the tech-heavy Nasdaq 100 index (represented by NDQ in blue). Source: Bloomberg

In contrast to the simplicity of dividends, implementing the four percent rule is more difficult, but there is considerable evidence that this approach is better, not only due to it being more tax efficient but also because the assets you invest in tend to earn more (as demonstrated in the above chart comparing the Nasdaq 100 ETF vs an Australian high dividend index ETF). Suppose you have $1 million. Rather than invest this in high dividend stocks or ETFs, you invest it in high growth stocks or ETFs that focus more on capital gains rather than dividends. You can choose NDQ, a Nasdaq 100 ETF, but if you want more diversification across countries and sectors, a good high growth ETF is VDHG, which invests in 90% global equities and 10% bonds. (Another ETF similar to VDHG but with slightly lower fees is DHHF.)

How to implement the 4% rule

When you retire, rather than rely on dividends, you simply sell off 4% of the value of the investments each year, so if you have $1 million you sell off $40k and then live off that for the first year. The expectation is that after you sell $40k then you will have $960k, but if we assume 7% annual growth then the next year your net worth will grow to $1.027 million and then you withdraw 4% of this, which is $41,088. This higher withdrawal in the next year accounts for inflation. (Note there is some uncertainty about whether, in this example of retiring with $1 million, you simply withdraw $40k each year or if you withdraw 4% of the new balance each year. I believe the latter option is safer because it explicitly accounts for inflation.)

The “four percent rule” is controversial with many arguing that it is only designed to last you thirty years. However, a simple fix to this problem is to withdraw 3% of your portfolio each year rather than 4% and, in my opinion, anything below 3% is far too conservative. Based on FireCalc.com, although the 4% rule fails with 95% probability after 30 years, the 3% rule is highly likely to last you forever. Basically if you are retiring in your 60s or 70s, you should be able to get away with the 4% rule, but if you retire any earlier, you should use the 3% rule instead.

The chart below made using FireCalc.com provides a simulation of historic stock market returns using the 4% rule and shows that over 70 years there is a good change you will not run out of money after 70 years but there is approximately a 10% probaility that you will (represented by lines going down below the horizontal red line).

Simulation showing the 4% withdrawal rate has an approximately 10% probability of failure over 70 years. Source: FireCalc.com

However, using the 3% rule, there are no probability where you lose your money (based on historic stock market performance), even under the assumption that you retire in your 30s and live for 70 years.

Simulation showing a 3% withdrawl rate being highly likely to last you forever. Source: FireCalc.com

The reason why selling off assets is more tax efficient is because capital gains are not realised until you sell the assets, which means you can sell them when you retire. By selling off assets when you retire, you do so when your income is low, which exposes more of your capital gains to low (or zero) income tax brackets. However, dividends are taxed once they are paid, which means that while you are working and accumulating assets, you’ll pay taxes on dividend income while your income is relatively high.

Capital gains are subject to Australian income tax rates once the capital gains are realised.

What will I do?

Early in my journey towards financial independence, I focused mainly on accumulating high dividend ETFs e.g. IHD and even HVST (see The Problem with HVST). When investing in purely Australian equities, I discovered that not only did my investments underperform but I also needed to pay taxes every year. To address this problem, I used a margin loan to borrow against my ETFs and diversify into international and emerging market equities more (e.g. I made some good bets on technology ETFs). Having a margin loan has its pros and cons, but one of the pros is that the interest on the margin loan is tax deductible, which helps to offset the tax paid on the dividends from Australian equities. Today Australian equities make up approximately half of my equities with the other half in international equities and a small amount of emerging market equities. Although I have a margin loan, I have started dabbling in NAB Equity Builder. NAB EB allows you to borrow at a lower rate compared to a margin loan.

While I am moving towards growth rather than dividends, I am still holding onto my high dividend ETFs. My plan is, rather than choose between dividends or growth, I will simply aim for both. There are many benefits of dividend investing e.g. franking credits. Furhermore, even though Australian high dividend stocks have underperformed in the last decade, there may be hope in the future as these companies enter the post-COVID future. If I sell Australian dividend stocks and use the proceeds to purchase global tech stocks, there is a very real risk that I will sell low and buy high, so rather than sell, I prefer to simply leave my Australian dividend stocks and ETFs. It should also be noted that there are other ETFs on the ASX that pay high dividends but do not invest in Australian equities e.g. UMAX uses options against the S&P500 to generate income; EBND invests in emerging market bonds and pays approximately 5% monthly; and TECH focuses on global tech stocks that have strong moats, and surprisingly this ETF has a dividend yield of approximately 9% paid yearly. I will discuss these non-Australian high-yield ETFs in a separate future blog post.

Property vs shares

Although it is clear that I have a bias towards shares over property, the strategy of selling down high growth ETFs exposes yet another benefit of shares vs property, which is the ability of ETFs to be sold in small chunks. If you have a $1 million property, you cannot sell half of it because no one will want half a property. You must sell it all in one go. Suppose you make $500k capital gains. Then $18200 of that will be exempt from tax while the rest of it is subject to tax, so you’ve managed to avoid tax on $18200. Now suppose you have $1 million in ETFs, which we will assume is $1 million all in VDHG. Rather then being forced to sell all of it in one go, you sell half of it in one year and the other half the next year. By doing this you realise $250k in each year. This exposes $36400 to the tax free threshold. By being able to sell smaller portions, you make the most of the tax free threshold.

Thanks to ETFs being highly divisible, I can sell off small amounts of ETFs each year thereby spreading capital gains across multiple years and exposing more capital gains to low tax brackets. Furthermore, any capital gains on assets held over one year receive a 50% CGT discount.

Another benefit of investing in ETFs rather than property is that you can sell ETFs cheaply e.g. selling one property will cost you about $20k to $30k in real estate agent commissions, but with ETFs you will pay about $20 or $30 to sell (or even $9.50 for discount online broker SelfWealth).

Other benefits of ETFs vs property is you avoid stamp duty and land tax. You also have access to franking credits.

Of course, in all fairness, there are some downsides of ETFs vs property e.g. the interest rate on NAB EB and margin loans are higher than those on mortgages, and although you can achieve leverage of about 70% using NAB EB or margin loans, you are able to achieve leverage of 80% up to 95% with property. In my opinion, even if you are able to achieve more leverage against property, it doesn’t necessarily mean you should. Leverage can magnify gains but also magnifies losses should the market go through a downturn. When leveraging into ETFs, you are able to diversify within the portfolio defensive assets such as bond ETFs (e.g. VDCO), hybrid ETFs (e.g. HBRD) or even gold mining ETFs (e.g. GDX), which reduces volatility. When you leverage into a property, you are all in one property in one place, exposed to an universified asset in one location. Many believe that property is safe compared to the volatility of the stock market, but if you invest in a highly diversified ETF, it is safer than investing in one property. The lack of volatility in property is actually the result of poor price discovery mechanisms rather than because property is inherently safer than shares. Once property is listed and exposed to the same price discovery mechanism of shares, property is highly volatile as evidenced by the price charts of residential REITs.

Disclosure: I own IHD, SYI, HVST, NDQ, UMAX, EBND, TECH, HBRD, and GDX.