Summary In an effort to help investors discover the broad opportunity set beyond the stock market, I am introducing a new weekly report called The Asset Class Weekly. My priority each week is to explore in depth an asset class that might not be on the radar screen for the average investor. The inaugural Asset Class Weekly will focus on emerging market bonds. When people think of investing, their minds typically turn to the stock market. This perspective is certainly understandable, as the financial media concentrates nearly all of its time discussing the many stocks of companies that people like to own. And when accessing their employee retirement programs, the menu of fund offerings is typically made up stock mutual funds of all styles, sizes and geographies along with token bond and money market offerings thrown in to round out the line up. But capital markets have so much more to offer to investors than just stocks. And these various other asset classes can provide investors with attractive returns opportunities as well as the ability to better control risk through more meaningful portfolio diversification. Introducing The Asset Class Weekly In an effort to help investors discover the broad opportunity set beyond the stock market, I am introducing a new weekly report called The Asset Class Weekly. My priority each week is to explore in depth an asset class that might not be on the radar screen for the average investor. The inaugural Asset Class Weekly will focus on emerging market bonds. More specifically, the analysis will concentrate on the U.S. dollar denominated sovereign debt from emerging markets. Emerging Market Bonds So what exactly are emerging market sovereign bonds? It is debt that is issued by the government of developing economies around the world. The list of countries that make up a measurable part of the emerging market bond universe is vast ranging from Mexico, Brazil and Venezuela in the Americas to Ukraine, Latvia and Hungary in Eastern Europe and China, Indonesia and Malaysia in the Far East. Why the focus on U.S. dollar denominated debt? This is because a large number of bond issuance across the emerging world are done in local currencies. Thus, U.S. dollar denominated debt offerings from emerging market governments helps neutralize for U.S. investors the currency risk that would otherwise come with investing in this category. For example, those with exposures to bonds denominated in local market currencies stand to benefit if the U.S. dollar (NYSEARCA: UUP ) is weakening relative to these local currencies, but will struggle if the U.S. dollar is strengthening versus these same currencies. And in the current market environment where the U.S. Federal Reserve remains determined to raise interest rates while much the rest of the world is intent on easing, the U.S. dollar has been strengthening markedly relative to many of these local emerging market currencies. Hence the focus on the U.S. dollar denominated offerings at least for now instead. Gaining Investment Exposure Three exchange traded funds make up nearly all of the assets in the U.S. dollar denominated emerging market sovereign bond market ETF space. They are the following: iShares JP Morgan USD Emerging Market Bond ETF (NYSEARCA: EMB ) $4.7 billion in total assets 0.68% expense ratio PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEARCA: PCY ) $2.7 billion in total assets 0.50% expense ratio Vanguard Emerging Market Government Bond ETF (NASDAQ: VWOB ) $514 million in total assets 0.34% expense ratio Why Emerging Market Bonds? Emerging market bonds provide measurable risk-adjusted return advantages and portfolio diversification benefits that makes the category worth monitoring for consideration in a diversified asset allocation strategy. First, U.S. dollar denominated emerging market sovereign bonds have a fairly low returns correlation relative to other key asset classes. Over the past eight years, the correlation of its weekly returns relative to the U.S. stock market as measured by the S&P 500 Index (NYSEARCA: SPY ) is a reasonably low +0.52. And when compared to the core U.S. bond market as measured by the iShares Core U.S. Aggregate Bond (NYSEARCA: AGG ), it has an even lower returns correlation of just +0.32. Moreover, it also offers a differentiated returns experience from its emerging market equity (NYSEARCA: EEM ) counterpart with a correlation of just +0.43. In short, emerging market bonds offer a unique returns experience that is measurably differentiated from the primary investment categories as well as emerging market stocks. Second, the category offers a “middle of the road” alternative from a return, risk and income perspective. For example, the S&P 500 Index has a 3-year historical standard deviation of returns, which is a way of thinking about risk in terms of the volatility of returns, at 12.21% along with a yield of 2.0%. The core U.S. bond market, on the other hand, has a far lower standard deviation of returns at 2.95% but also offers a yield to maturity of 2.4% that is not much higher at present than the dividend yield on the stock market. As for emerging market stocks, they are even further out the risk spectrum than U.S. stocks with a standard deviation of 16.65% along with a yield of 2.2%. But emerging market bonds offer investors a middle ground between these options with a standard deviation of 7.17% that is higher than core U.S. bonds but lower than U.S. stocks and a yield to maturity that is meaningfully higher toward 5.7%. Third, U.S. dollar denominated emerging market bonds have held up fairly well in the recent market environment. Since the start of 2014, the ETFs in the category have fallen in the middle of the returns range relative to U.S. stocks and core U.S. bonds. (click to enlarge) The category has also meaningfully outperformed its emerging market equity counterpart. (click to enlarge) And drawing back from a longer term perspective, we see that since the early days of the financial crisis eight years ago at the start of 2008 through today, emerging market debt has delivered a comparable total returns experience to the U.S. stock market with less price volatility along the way. This strikes a stark contrast to emerging market stocks that tracked the S&P 500 Index through the early post crisis years only to have fallen flat over the last four years since the summer of 2011. (click to enlarge) Thus, based on its overall characteristics, there is much to like about the category at any given point in time both from an individual returns and portfolio construction perspective. What Accounts For The Returns Difference Between EMB and PCY? When considering an allocation to U.S. dollar denominated emerging market sovereign bonds, it is important to note that meaningful differences exist between the construction of the iShares JP Morgan USD Emerging Market Bond ETF and the PowerShares Emerging Markets Sovereign Debt Portfolio. First, the EMB much like the smaller VWOB has a far larger number of individual bond holdings relative to the PCY. For while the EMB has 846 holdings, the PCY only has 89. Second, the EMB and PCY will have different effective durations at any given point in time. At present, the EMB has a duration of 7.05 years versus the PCY at 8.21 years. Both of these duration readings are longer than that of the core U.S. bond market as measured by the AGG currently at 5.30 years. Lastly, the country mixes that make up the EMB and PCY portfolios are very different from one another. And unlike EMB, the PCY is designed to maintain equal weights across its emerging market sovereign debt allocations. As a result, the exact nature of the risks driving either portfolio can be entirely different at any given point in time. The following are the top 10 country weights that make up the EMB portfolio as of November 19. Mexico 6.20% Russia 5.61% Turkey 5.41% Indonesia 5.16% Philippines 5.11% Brazil 4.51% China 4.03% Hungary 4.02% Colombia 3.85% Poland 3.71% In contrast, the following are the top 10 country weights that make up the PCY portfolio as of November 20. Ukraine 6.48% Russia 4.26% Venezuela 3.82% Pakistan 3.66% Qatar 3.63% Latvia 3.62% Romania 3.57% Croatia 3.57% Lithuania 3.55% Poland 3.53% In short, these are two very different products from an individual emerging market country exposure perspective. This is a risk element that is important to evaluate closely before making an allocation to either product. Are Emerging Market Bonds Worth An Allocation Today? Despite all of the merits associated with an allocation to emerging market bonds in a diversified asset allocation strategy, I am not recommending an allocation to U.S. dollar denominated emerging market bonds at this time. This does not mean that I am not actively monitoring to potentially make an allocation to the space at some later date in time. But I am inclined to stand away from the category at the present time for the following reasons. To begin, while the option adjusted spread over comparably dated U.S. Treasuries has widened notably from its lows from the summer of 2014, at 349 basis points this yield spread remains somewhat low to average at best from a long-term historical perspective. Perhaps more importantly, this yield spread may not be fully reflecting some of the mounting short-term to intermediate-term risks facing the category at the present time. Many emerging market sovereigns are in the throes of an economic slowdown to varying degrees. A number of these countries are major commodities exporters, and they have suffered mightily from chronically declining prices for materials such as copper and oil amid supply gluts and declining global demand from the likes of China. And with the U.S. dollar strengthening and the Federal Reserve now considered likely to raise interest rates in December, the economic headwinds may become worse before they get better for many of these countries. The recent decision by S&P to demote emerging market giant Brazil to junk status following the recent credit rating downgrade highlights the current challenges facing some of these emerging market nations at the present time. Lastly, despite their solid recent performance, emerging market bonds are not without the risk of a major price decline at any given point in time. For example, back in 1998 during the outbreak of the Asian Crisis, emerging market bonds plunged by -42%. It should be noted, however, that the financial health of many emerging market nations is vastly better today than it was in the late 1990s. In 2008, emerging market bonds dropped by -34%. And the periodic decline of -10% or more like those seen in 2013 and 2014 should not be ruled out at any given point in time. Recommendation U.S. dollar denominated emerging market bonds have a solid long-term track record of risk-adjusted returns performance and are well suited for inclusion in a diversified portfolio allocation. But at the present time, investors may be well served given generally high valuations coupled with currently weakening economic conditions across the emerging market bond space to exercise patience by waiting to make a long-term commitment to the category. History suggests the potential for periods of downside price volatility that would provide a more attractive entry points. Thus, investors are encouraged to actively monitor the asset class for any sustained period of price weakness to reevaluate the possibility of adding U.S. dollar denominated emerging market bonds to a diversified long-term investment portfolio at that time if fundamental conditions are warranted. Disclosure : This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.