The market where bonds beat equities

• Level: Advanced
• Reading duration: 6 minutes

Performance of bonds and equities in Emerging Markets

Equities are for growth and government bonds are for defence, right? Everyone knows that! My grandma’s cat knows that. Except, there’s a place where that rule does not hold. And that place is the Emerging Market. Here’s the data (EM bonds are the orange line, equities are blue): The chart shows the longest possible comparison between an Emerging Market equities ETF (IEEM) and an Emerging Market US$ denominated sovereign bonds ETF (SEMB). The bond ETF has delivered twice the return of the equity's product over 16 years: That’s a 189.3 % cumulative return for Emerging Market US$ sovereign bonds vs 86.6 % for Emerging Market equities. Incredibly, the EM bond ETF has delivered better returns for less risk than its equities rival, too: The return/risk ratio shows that EM bonds were a much cushier ride than EM equities. The higher that number, the better your risk-adjusted returns. Or, to put it another way, the less risk you took for every percentage point of return gained. And who wouldn’t want to own an investment that grew your wealth faster, while causing less pain than the alternative?

Reasons for the success of Emerging Market bonds

The trend holds true using index data going back to 1994 (before Emerging Market ETFs even existed). Moreover, there are tangible diversification benefits to allocating to EM US$ sovereigns instead of (or in addition to) EM equities. Emerging Market equity ETFs are typically heavily exposed to Asian firms. EM US$ bond ETFs split more evenly across emerging markets while leaning into Latin America and the Gulf States. And if you hold a global ETF, then it’s worth knowing that EM US$ sovereign debt is historically less correlated with that asset class than Emerging Market equities. State Street report 20-year EUR return correlations with the MSCI World as follows:

• EM US$ bonds: 0.52
• EM equities: 0.73

That’s a meaningful diversification advantage if the historical correlation holds.

What future developments can be expected?

You know there’s a “but” coming… The big “but” is we can’t know that EM bonds will continue to outperform EM equities in the future. In fact, the spoils have gone to EM equities in recent years. A three-year comparison shows a neck-and-neck race: But equities have dominated over five years: Recovery from COVID, deglobalisation, inflation, and the outbreak of the Russia-Ukraine War weighed more heavily on EM US$ debt than EM equities. Equities also scored a significant victory over the last 10 years: Profits were 20 % higher in the equities ETF versus its bond rival in this case. Finally, we can see that EM debt substantially built its lead in the first five years of the comparison: The bond return was 371 % greater than the equity return from 2008 to 2013: Why? Because Emerging Market government finances recovered more quickly than expected from the 2008-09 Global Financial Crisis (GFC). EM US$ bond yields peaked at the height of the panic in October 2008. You can see that was the lowest point for EM debt prices in the line chart above (orange line). Rising bond yields mean falling bond prices, while falling bond yields mean rising bond prices. EM yields fell steadily for the next four years propelling the bond ETF upwards. That said, the catch is clear: EM US$ bonds may not maintain their historical advantage over EM equities. Indeed, that advantage has not materialised over the past decade, as the snapshot above shows.

Should you include Emerging Market bonds or equities in your portfolio?

First of all, let’s acknowledge that Emerging Market equity returns have been relatively weak for many years now. Any asset class can suffer a poor run. But Emerging Market countries are an important part of the global economy, and EM equities are a useful portfolio diversifier. As we’ve seen, there’s evidence that EM US$ debt is a better diversifier still. Plus, risk-adjusted returns are still higher with EM bonds than with EM equities. However, EM bond investors typically do well when yields and credit spreads are high. When elevated, those two metrics imply that investors believe that Emerging Market bonds are riskier than usual. The pay-off comes if those fears prove overblown and the economic fundamentals improve. Then risk-taking debt investors are well positioned to reap the rewards of falling bond yields and tightening credit spreads. This explains a large amount of EM US$ sovereign’s success post-2008, and indeed post-1994 (Mexican Peso Crisis), and post-1997-98 (Asian Financial Crisis). By credit spreads, we mean the difference in yield between two different bond types that is caused by their differing credit ratings. For example, the EM US$ bond ETF, SEMB, is broadly comparable with the European Government bond ETF, SEGA. (Duration is the key metric here). SEMB’s average yield-to-maturity (YTM) = 6.41 % SEGA’s YTM = 2.75 % The approximate credit spread between them is 3.66 % (6.41– 2.75). Both the yield and spread are way off their historical highs. In fact, the spread is on the tight side. And while those metrics can’t predict the future, neither do they imply that EM sovereign debt is poised to catapult ahead. All told, Emerging Markets are a riskier place to invest than the Developed World alternative. But that’s precisely why they have diversification potential, and why they can confound our expectations with strange results like bonds beating equities over 16 years.

Investing in Emerging Market US$ Sovereign Bond ETFs

Here are a few pointers if you’re interested in exploring EM US$ debt ETFs: Emerging Market bonds are much riskier than their developed world counterparts. The credit quality of their holdings is far worse and typically includes a high proportion of junk bonds. That’s one of the reasons the product has a high yield. Cast your eye back over the charts. EM bonds generally tumble during stock market downturns such as the GFC and during the Covid crash. They actively suffer during flight-to-quality spells when investor’s seek refuge in safer assets. Therefore, EM debt allocations should be carved out of the equity side of your portfolio, not the defensive bond side. There is no need to currency hedge EM US$ debt for the same reason most investors do not currency hedge equities. That’s because foreign currency exposure may provide a diversification benefit on the growth-side of the portfolio while making little difference to overall portfolio volatility. Currency exposure in this case is to the US dollar. In short, think of EM debt holdings as equity-like in their behaviour not bond-like. Bond fund taxation is typically higher than with equities. Bear that in mind if you cannot fit your bond holdings in tax shelters. Finally, check out our justETF academy for more on bonds.