Would you invest in these bonds?
Imagine somebody offered you the possibility to invest in a bond of a company. The bond has a maturity of 41 years and is pretty risky. In fact, in the 41 years to maturity, the issuer is likely to default on average twice and the bond is likely to be in default in about two out of five years. Would you invest in this bond? And if so, how large do you think the return on this investment will be?
What I have described to you is the experience of investors in emerging market sovereign bonds since the Battle of Waterloo in 1815 according to a new paper by Josefin Meyer, Carmen Reinhart and Christoph Trebesch. They looked at hard currency sovereign bonds traded in London or New York over the last 200 years and the risk and return of these investments. And they make a pretty good case of investing in these bonds, despite the risks.
The risks for bond investors are indeed manifold. Over the last two centuries we had two World Wars, several episodes of hyperinflation and lots of other fun things that will give an investor grey hair. In total, the researchers find 313 cases of defaults affecting 1,134 different bonds. And despite this large number of defaults leading to emerging market bonds being in default for quite a large share of their lifetime, as we have seen above, the returns were spectacular.
Our chart shows the average annual return of these emerging market sovereign bonds in comparison to US and UK government bonds and equities. Historically, emerging market bond returns have had returns above the UK equity market and below the US, but since 1995 emerging market bonds have beaten even US equities. One reason for this strong performance of emerging market bonds is that defaults are much less destructive to investor capital than many investors think. The average haircut for investors before 1970 was 51%. After 1971 this dropped to 39% and in the modern bond exchanges practiced since 1998, where investors get compensated for defaulted bonds with new bonds with longer maturities and/or lower coupons, the haircut has declined even more, to 37%. Since 1970 there has not been a single bond default when investors lost all their invested capital and the maximum loss in a modern bond exchange since 1998 has been 77%.
Because the capital is less at risk than many investors think and these risks have declined over time, the volatility of emerging market bond prices is significantly lower than for equities and only a little bit above 10-year government bonds in the UK and the US. As a result, risk-adjusted returns as measured by the Sharpe ratio are higher for emerging market bonds than for any other asset class shown in our chart.
And yet, whenever I write about the long-term track record of emerging market bonds, what I remember afterwards are the number of defaults, not the returns. And consequently, I like so many other investors have an uneasy feeling about these investments. This is normal behaviour because as psychologists know, we react about to three times stronger to a loss than to a comparable profit. This loss aversion gets stronger if we do not understand what is going on in an investment because with ignorance comes increased uncertainty and a lower threshold to abandon an investment. This a fate that emerging market bonds share with hedge funds. As long as performance is positive, we acquiesce to the investment and ride the rollercoaster upwards to its peak. But once the performance turns negative, we have a hard time justifying a continued investment because we have little data or insight to hold on to and justify the investment to ourselves or our stakeholders.
Familiarity is a wonderful mental trick to calm us down in the face of risk and uncertainty. Every investment adviser has stories about clients who prefer to invest in the shares of a company they know (e.g. Vodafone) while shunning a potentially much more attractive investment in a company that may be very similar but unknown to the investor (e.g. Proximus for a British investor). As a result, these “unknown” investments carry a systematic risk premium.
A wonderful example from my past career in Switzerland is the Swiss corporate bond market. The Swiss Bond Index (SBI) differentiates between domestic issuers and foreign issuers. Mind you, these foreign issuers are companies like Toyota, HSBC and other blue-chip names. Yet, on average, bonds by foreign issuers have a higher yield to maturity than a comparable bond by a domestic issuer. There are some differences in the tax treatment of foreign and domestic issuer bonds, but the annual performance difference of 3.0% for foreign issuers vs. 2.65% for domestic issuers cannot be explained by this tax effect. A lack of familiarity goes a long way…to create extra returns for those investors disciplined enough to hold on to these investments for the long run.
Long-term performance of emerging market bonds
Source: Meyer et al. (2019), Fidante Capital.