MichaelFabian

Michael is a managing partner at FMD Capital Management. a fee-only registered investment advisory firm specializing in exchange-traded funds. Michael is the leader of the FMD investment committee where he implements actively-managed income portfolios using ETFs, mutual funds and closed-end funds. His investment philosophy is aimed towards designing portfolios that are low in volatility while still providing a high income stream, then shift in response to changing market environments. He also implements active risk management practices to protect his investors from ultimately experiencing a large loss. He regularly contributes his views on wealth management in his company blog. podcasts and special reports. You can follow Michael on Twitter @fabiancapital or email him at Michael@fmdcapital.com.

Michael ‘s Latest Posts

Although it has been a winding road for nearly all fixed-income investors over the past year, emerging market bond investors have especially had their fair share of white-knuckle moments.

Prices corrected drastically during the May-June interest rate backup, but moving forward we could see superior performance from U.S. listed emerging market bonds juxtaposed to their domestic counterparts. Those investors with a long history of dabbling in this space are probably accustomed to the higher than average volatility. However, with the recent resurgence and extension in price of domestic high-yield bonds, emerging market bonds might be next in line for a comeuppance.

It’s always difficult to say, but the opportunities appear interesting from a comparative point of view. Especially if you believe the global expansion that is currently under way will continue. I believe that a successful fixed-income strategy in 2014 relies on an investor’s cognizance of the options available to them. In addition to how they might be able to use these tools within a diversified portfolio. For that very reason, emerging market bonds should be included in every retirement income seekers play book.

For the purposes of evaluating retail investment options, the emerging market fixed-income universe could be divided into three different issuer types: Sovereign, Quasi-Sovereign, and Corporate. The first issuer type could be best explained as a treasury bond of a foreign nation. Just as the U.S. Treasury issues bonds to fund our government operations, so do treasurys of emerging market nations. The price fluctuations of these particular bonds depend largely upon the political stability of the regime, alongside the credit rating and interest rate policies of the issuing currency. To put it another way, why would anyone expect the yield on a 10-year U.S. Treasury note to be the same as a 10-year U.S. dollar denominated Brazilian bond? They obviously wouldn’t, which is why an investor receives a premium in yield for the additional risk of lending money to a foreign government which might not have the laws, financial strength, or political stability as the U.S. government.

The next issuer type fits directly in between the concept of traditional sovereign debt and corporate debt. A quasi-sovereign issue could be categorized as a company or business enterprise that is state-sponsored or of extreme importance to the stability and GDP of the host country’s economy. Using the same example, a quasi-sovereign could include a company within Brazil such as Petrobras, an oil and natural gas behemoth. The closest comparison you could make within the U.S. would be a bond issued by one of the GSE’s; or government sponsored enterprises such as Fannie Mae or Freddie Mac. At its fundamental core, it’s important for investors to keep in mind that emerging market nations are still primarily natural resource based or export-driven economies. This is why you will typically see quasi-sovereign issues in sectors such as oil and gas, metals and mining, or even banking. The bonds of these large companies will traditionally fluctuate with interest rates, company earnings and balance sheet strength, but might also be impacted by accommodative foreign policies or special tax treatments.

Finally, the last issuer type is a straight forward, easy to understand version of corporate debt. Which in turn responds to many of the same areas quasi-sovereign bonds do, but with a focus on economic expansion and corporate health. They face the very same challenges as corporations do domestically, yet will yield more due to structural differences between our economy and the host countries. This is the primary reason why corporate issuers in emerging market nations might have lower overall indebtedness, yet will pay more to investors to finance their debt when put against a comparable company with operations based in the U.S.

With these three primary issuer types in mind, selecting a fund boils down to manager or index strategy alongside your confidence in government or private debt. For those interested in a tilt toward government, you could easily use a large liquid index product such as the iShares JP Morgan Emerging Market Bond ETF EMB, +0.12% or the Vanguard Emerging Market Government Bond Index VWOB, +0.31% Both ETFs are broadly diversified, carry reasonable expense ratios, and have long index histories. The ease of use of these two funds makes them even more attractive than a mutual fund to quickly add exposure or hold for a limited period.

For those investors seeking a tilt toward corporate issuance, I recommend using an active manager. In my experience, expertise in credit research and ongoing risk monitoring can play a pivotal role in a successful investment outcome. The WisdomTree Emerging Market Corporate Bond ETF EMCB, -0.36% and the DoubleLine Emerging Market Fixed Income Fund DBLEX, -0.19% make excellent options for those seeking a manager that can target fundamentally sound areas of the market, or overweight appealing industry groups within an individual nation.

Sizing your allocation to emerging market bonds is key to establishing a well-balanced portfolio, which is why we limit our exposure to between 10%-20% of our total bond sleeve within our Strategic Income Portfolio. For example, if the total fixed-income allocation within your portfolio is 50%, I wouldn’t recommend going over 5%-10% of your total portfolio with one, or even a combination of several of the funds listed. This should limit your risk, and ensure that you don’t become overexposed to this sector of the market.

Overall emerging market bonds can be a great yield enhancement tool for a retirement income portfolio when sized and distributed correctly. I am a firm believer that income investors should avoid local currency bonds at all costs due to the added risk of currency volatility. In a real world environment, investors should concern themselves primarily with getting the allocation size, credit quality, and issuer type correct and avoiding trying to capitalize on currency pairs.

For those investors that might not want a dedicated position in emerging market bonds, a good multi-sector fixed income fund that makes up a core position within your portfolio could make a lot of sense. My favorite example is the Pimco Income Fund PIMIX, +0.16% Formulating a plan, then implementing it decisively, will pave the way to exposing your portfolio to various areas of the bond market that could prove to be profitable and effective.