Bonds: it's not all bad news

In spite of expected further rises in global interest rates, I would still invest in bonds. It is not true that all types of bonds perform badly when interest rates rise. The reality is that the markets include a wide variety of borrowers and securities that behave differently under the same global conditions. One way to look at the global credit markets is to consider them in three broad categories: emerging market bonds, high-yield bonds and distressed debt.

Emerging market bonds

Emerging market bonds include coupon-paying bonds issued by emerging market sovereign governments and corporate borrowers. The sovereign securities are neatly captured in the JP Morgan Emerging Market Bond Index Plus (EMBI+), which consists of 19 countries’ US-dollar-denominated bonds. Of course, individual country dynamics are important. For example, Russia (an oil exporter) has benefited from high oil prices, while the Philippines (an oil importer) hasn’t. But broadly speaking, the outlook for emerging market country government debt has improved over the past five years.

Nonetheless, these bonds have attracted high levels of speculative activity, which makes them highly sensitive to global events, such as rising interest rates. Indeed, given my view that US Treasury bond yields are set to rise further, I’m concerned that emerging market sovereign bonds will also come under pressure. With many sovereign bonds yielding little more than 8%, there isn’t much of a cushion to compensate investors for the risks. Therefore, I think the best approach is to move in and out of the sovereign markets tactically, taking advantage of any opportunities to exploit short-term trends or anomalies.

There are much better opportunities among emerging market corporate borrowers, where the impact of rising interest rates tends to be compensated for by better earnings growth, especially in the early stages of an economic recovery. In addition, corporates attract less speculative activity because issue sizes are smaller. So, although I expect rates to rise and am unenthusiastic about Brazilian government debt, I hold a number of Brazilian corporate bonds yielding between 12% and 14%. I believe these yield levels compensate for the underlying risks. In my two funds, I hold 30 coupon-paying bonds issued by companies in 20 emerging market countries.

High-yield bonds

High-yield bonds are coupon-paying bonds issued by firms in the developed world, such as the countries of the European Union. Adding these securities to the portfolio helps to diversify risk away from emerging markets. I hold a number of bonds issued by corporates in Europe, all of which yield 10% to 15% a year - again, I believe this sufficiently compensates for the risks.

Distressed debt

Distressed debt refers to defaulted debt of sovereigns and corporates in both emerging and developed markets. These securities behave differently from coupon-paying ones because they are influenced by bottom-up, event-driven factors, rather than global macro conditions.

For example, the value of Côte d’Ivoire government debt - a sovereign in default and trading at around 16 cents in the dollar - largely depends on the outcome of negotiations between warring local factions, rather than on the value of US Treasury bonds. It is also sensitive to the outcome of an eventual debt restructuring, should that occur. Argentinian government bonds are another example of sovereign distressed debt, but I am avoiding these because I believe that the outcome of any restructuring is likely to leave the bonds trading below where they are at the moment. I also hold several distressed corporate bonds, whose trading behaviour is more akin to equities than coupon-paying bonds.