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Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank’s main bond fund.

U.S. General George Patton famously mused: “Take calculated risks. That is quite different from being rash.”

This was from a guy who survived two world wars only to die in a freak car accident.

One of the riskier assets for investors today is emerging market debt and indeed, with that risk comes opportunity. Bonds of less developed countries have often proven to be a profitable and viable asset class. For income investors, their yields are enticing.

But given the elevated economic risks we are seeing across the globe, is it too early to buy these credit instruments?

And what will happen to these bonds if, as expected, the world sees increased deglobalization? This would mean less economic interaction between countries, especially between developed and less developed ones, and less trade means less need for international lending and borrowing.

The performance of emerging market debt has been painful of late. The iShares J.P. Morgan USD Emerging Markets Bond ETF, for instance, has fallen 30 per cent since the beginning of 2021. By comparison, the 10-year U.S. Treasury bond has fallen about 21 per cent.

While prices of emerging market debt have tumbled, yields – which move inversely – have risen dramatically.

The developed world’s most important benchmark, the 10-year U.S. Treasury, has seen yields rise from 1.2 per cent to 4 per cent in absolute terms since the start of 2021. At the same time, the spread in yields between U.S. Treasuries and emerging markets debt has risen from about 280 basis points to more than 380 basis points. (There are 100 basis points in a percentage point.)

Less than two years ago, emerging market debt was trading at yields near 4 per cent – about what U.S. Treasuries are currently fetching. Now, they’re going for 7.8 per cent.

Let’s be clear: Earning a 4-per-cent absolute yield on the debt of emerging market bonds was ludicrous. The many problems and issues facing lesser developed countries are obvious to anyone. Earning only 4 per cent for a risky fixed-income asset seems like a pretty bad deal.

The yields being offered today, however, are beginning to look more interesting. If you’re considering gaining exposure to emerging market debt, consider these three things.

The first is the outlook for the so-called risk-free rate – essentially the interest an investor can expect from a risk-free investment such as U.S. Treasury bonds.

Treasury yields may be nearing a short- to medium-term plateau, as inflation should decline from recent levels as the economy weakens in 2023. So rising risk-free interest rates – which would push down the price of the bonds – is becoming less of a concern.

The second is the yield spread between Treasury bonds and the U.S. denominated bonds of emerging-market countries.

Present spreads still concern me. At 380 basis points, spreads are wide relative to more stable times but are nowhere near the level one would expect given the state of our economic and political world. The ICE BofA Emerging Markets Corporate Plus Option-Adjusted Spread hit 600 basis points during the 2020 COVID-19 meltdown. This spread hit more than 1,300 basis points during the financial crisis of 2008. Either the market is not pricing in the risk of this asset class or market players are betting on a sharp economic turnaround or a bailout by developed countries.

The third thing an investor must consider is default risk.

Given the meteoric rise of debt-to-GDP ratios, the war in Ukraine, supply shocks, runaway population growth and the trend toward deglobalization, default risk has risen. Lenders will very likely have to take losses in the form of outright defaults or debt restructurings in 2023. Many emerging countries are struggling, and one cannot get blood from a stone. Some debts will need to be forgiven. At some point, spreads will reflect this harsh reality.

Creditors – in this case fixed income investors – are responsible for risk assessment and due diligence. Borrowers are responsible for only borrowing as much as they can reasonably afford.

All things considered, I think it’s too early to buy emerging markets bonds. They will underperform developed market debt significantly if the world economic situation continues to deteriorate. If the situation gets really ugly, investors may want to avoid emerging market debt for a long time.

However, we should eventually see a major buying opportunity. Investors who bought when spreads were above 750 basis points in the past ended up doing very well – and profited more quickly than most investors expected at the time.

If and when spreads widen to 500 basis points, investors may want to gain more exposure to this asset class. Just beware you may need to be patient and brave; when spreads blow out people tend to think the world is ending.

And if you do invest, use well-diversified exchange-traded funds. Picking specific relative winners and losers in emerging markets is very difficult even for so-called professionals.

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