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Brazil's President Dilma Rousseff, Russian President Dmitry Medvedev, Indian Prime Minister Manmohan Singh, Chinese President Hu Jintao and South African President Jacob Zuma join their hands together during a group photo for the BRICS Summit of emerging market nations in New Delhi March 29, 2012. (B MATHUR/REUTERS)
Brazil's President Dilma Rousseff, Russian President Dmitry Medvedev, Indian Prime Minister Manmohan Singh, Chinese President Hu Jintao and South African President Jacob Zuma join their hands together during a group photo for the BRICS Summit of emerging market nations in New Delhi March 29, 2012. (B MATHUR/REUTERS)

Expert’s Podium

Bonds emerge from developing markets Add to ...

I’ve spoken before about the need for income investors to diversify their income portfolios. Simply put, the “set it and forget it” portfolio of government bonds looks like an increasingly risky proposition these days.

(Indeed, this seems to be what the pros are doing. Superstar PIMCO manager Bill Gross has trimmed his U.S. Treasury bond position in his Total Return Fund to about 12 per cent as of October 31. Back in January, it was 29 per cent.)

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One possible solution to this problem is emerging markets. Emerging market (EM) bonds have recently become an asset class that HNWIs (High Net Worth Individuals often pronounced “hun-wees") have started to become very interested in.

The performance of EM bonds has been fairly impressive lately. As of the start of October, The Barclays Capital Global Emerging Markets Index is up 15.10 per cent this year. Compare that with a 3.77 per cent gain for the Barclays Aggregate Bond Index.

I understand this is an extremely short time frame. But the long-term picture looks good too. The graph below tracks the performance of emerging market bonds (JP Morgan Emerging Local Markets Index Plus ELMI+) to the broader global bond market (JP Morgan Global Bond Index GBI) over the past 15 years or so. As you can see in this chart, there’s volatility there. But there’s performance too.

Looking into the future, this story should continue. As developed markets (DMs) struggle to get their fiscal houses in order, emerging economies are expanding. As a result, the debt-to-GDP ratios in EMs are considerably better than in many DMs.

I recently spoke with Bart Turtleboom, Portfolio Manager and Co-Head of Emerging Markets at MAN GLG. The company is the world’s largest publicly traded Hedge/Alternative Money Manager, based in the U.K., with about $60-billion under management.

Mr. Turtleboom has been an EM analyst and manager for almost 15 years, long before EM bonds became popular. Before that, he worked for the International Monetary Fund. Suffice it to say, when it comes to emerging markets, he is one of the smartest, most insightful investment professionals I’ve ever spoken to.

“The fixed income markets in many emerging markets have deepened significantly over the last 10 years,” Mr. Turtleboom told me. “Not only has demand increased far beyond a few big DM funds, the sophistication and unmet need from locals as they build and diversify their own portfolio also has fuelled a more liquid, transparent and tradeable market.”

Mr. Turtleboom believes EMs are a pretty good place to invest. “Most EM sovereign balance sheets look currently superior to the average DM country,” he said. “In addition, EMs often have further potential due to better demographics, access to commodities, etc.”

I asked Mr. Turtleboom about currencies – one of the questions I’ve always had about EM bonds. When you invest in foreign currencies, you have to translate your money back into loonies. That can eat up a lot of your gains. “This is a very important question,” Mr. Turtleboom admitted. “We see [currencies] as a separate asset class, deserving an active decision to hedge. Too many times we see in the market that the majority of returns of an equity manager is derived from [currencies] rather than from security selection.”

If you’re interested in exploring the world of EM bonds, here are a few quick tips, based on strategies utilized by Mr. Turtleboom and the HNWIs I know.

Diversify, diversify, diversify

This is not the place for all-in bets. Despite their improving financial profile, EMs do carry a good deal of risk. Over the past several decades, there have been several EMs that have defaulted on their debts, including Argentina in 2002, Russia in 1997, and Mexico in 1982. Diversification should be a top priority.

Avoid foreign currencies

I’m with Mr. Turtleboom on this one. Investing in EMs is difficult enough; leave currency for the speculators and pick a product that allows you to hedge back to a major currency (USD or CAD).

Think about active management

Over the past several years, there have been a number of low-cost ETFs that invest in EM bonds; many of these can be excellent investments. But EMs are one area where imperfect/incomplete/inaccurate information is a real danger. For that reason, it makes sense to work with a pro in this space. Yes, you’ll pay more in fees, but this is one area where you don’t want to be penny wise, pound foolish.

Active managers can also employ strategies to mitigate some of the political and other risks that accompany EM bonds. Just as an example, Mr. Turtleboom’s emerging markets fixed income portfolios also allow him to go long and short on individual issues, and to hedge his currency exposure. Some won’t want to pay for such “bells and whistles.” Myself, I believe the extra protection is worth it.

Complement, not replace

I want to be clear here: I’m not suggesting we liquidate our current bond portfolios and replace them with EM bonds. As you can see from the graph above, EM bonds can be more volatile than government bonds from Canada, U.S., or other developed nations. For that reason, they should be considered a diversification tool, and an attractive way to add some alpha to the overall portfolio.

An allocation of 15 per cent to 20 per cent of the fixed-income portfolio (5 per cent-8 per cent of the overall portfolio) would be suitable for most investors; perhaps a little more for those who are comfortable with a little more volatility, or those with deep knowledge of a given market.

Thane Stenner is founder of Stenner Investment Partners within Richardson GMP Ltd., as well as portfolio manager and director, wealth management. Thane is also Managing Director forTIGER 21 Canada. He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors)’.www.stennerinvestmentpartners.com (Thane.Stenner@RichardsonGMP.com). The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund.

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