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.