December 21, 2003
PORTFOLIOS, ETC.
Emerging-Market Bonds May Be Better Than Junk
By JONATHAN FUERBRINGER
EXT year, the bond market faces the possibility of its first down year since 1999, so many analysts are advising investors to look at riskier, higher-yielding bonds to provide a cushion against losses elsewhere.
While holding a portion of high-yielding junk bonds is a good idea in a broad bond portfolio, some investors are still unaccustomed to including a dollop of bonds from emerging markets, largely because they have a widely publicized history of defaults, from Russia to Ecuador.
Emerging-market bonds, however, are actually less risky than junk bonds. The average credit rating for the Lehman High Yield Index of junk bonds is between Ba and B2, three to four notches below investment grade. The rating for J. P. Morgan's Emerging Market Bond Index-Global is Ba2, just two notches below investment grade. Since 1998, the percentage of bonds in the index rated investment grade has risen to 48 percent from 8 percent.
Still, this sector has nearly matched the performance of junk bonds this year, with emerging-market bonds up 25.5 percent through Thursday and junk bonds up 28.5 percent.
Mohamed A. El-Erian, head of emerging-markets portfolio management at Pimco, the mutual fund company, says the improved credit quality in emerging markets is one reason he does not expect these markets to stumble this year.
A rise in interest rates in the United States is unlikely to hurt emerging markets, Mr. El-Erian said, as long as the rates rise because of steady economic growth here. That growth would increase demand for products from emerging-market countries and would be good for the governments and companies issuing bonds, offsetting the negative impact of higher interest rates.
He said that a surge in interest rates as a result of a swift and disorderly decline in the dollar was possible and would hurt emerging markets, just as such global financial disturbances have undermined them in the past. But he is not expecting such a decline.
China could play an important role in determining the fate of the dollar and commodity prices, in turn influencing other emerging bond markets next year.
If the Chinese government alters its currency's peg to the dollar, the dollar's fall could accelerate, especially against other Asian currencies. But while the Bush administration is pushing for such a change in Chinese policy to help American companies that compete with China, many analysts think that any easing of the peg will be gradual and not disruptive. The Chinese are helping to move commodity prices higher, as Chinese companies buy copper, iron ore and other basics to feed their factories.
Many emerging-market countries, like Russia, Venezuela and Peru, depend on the export of commodities, from oil to copper. If commodity prices keep rising, that will strengthen these countries' economies and, in turn, the credit quality of their bonds.
Despite these positives for emerging-market bonds, Mr. El-Erian said, picking specific credits next year will be more important than this year, when almost any emerging-market bond has been profitable. Government bonds from Venezuela, with all its political problems, have a total return of 39.4 percent through Thursday, according to J. P. Morgan. Bonds from Ecuador, which defaulted on its debt in 1999, have a return of 99.5 percent. Bonds from Turkey, which shares a boarder with Iraq, have a total return of 31.5 percent.
FOR 2004, Mr. El-Erian still likes bonds from Brazil, Russia, Mexico, Peru, Tunisia, Ecuador, Panama and Ukraine. Among the countries he is avoiding are Turkey, Venezuela, Hungary and Poland. Venezuela is too explosive politically, he says, Turkey is too expensive and Hungary and Poland have a bumpy road ahead.
Even with careful bond selection, analysts don't expect this year's superb performance to be repeated next year. Mr. El-Erian says he is unlikely to come close to repeating the 32.2 percent return of the Pimco Emerging Market Bond fund, which is beating its benchmark, the J. P. Morgan emerging-market index, by almost seven points.
"Nine to 12 percent is both realistic and attainable,'' he said.
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