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GEM Bond Funds: A New Fund Available March 3, 2006
We look at the performance of the ABN AMRO Emerging Market Bond Fund versus its peers.
Author : Mah Ching Cheng


Untitled DocumentGLOBAL EMERGING MARKET BONDS:
New Fund Added To This Attractive Asset Class

Do you think that bonds can only achieve mediocre returns? Think again. There is a class of global bonds that has been delivering strong returns in the past few years. Emerging market bond funds investing into the sovereign fixed income instruments of emerging markets like Brazil, Venezuela, Russia etc have been performing quite well. The JP Morgan EMBI Global Index, a common benchmark for emerging market bond funds, returned 12.8% in 2005. The annualized returns for the past five years was 9.9% (as at end Jan 2006 in SGD terms). It is quite a feat for a fixed income asset class to provide such strong returns. What were some of the factors underpinning the strong performance of this asset class? What are some of the reasons to invest into these bonds?

Aside from explaining the asset class, we will also look at the performances of the emerging market bond funds on our platform, including those of a new entrant – the ABN AMRO Global Emerging Markets Bond Fund (USD) (the EUR denominated version fund is also available, click here for the factsheet) and , whose performance tops this category.

Higher Yielding Sovereign Bonds

Emerging Market government bond funds usually invest in the sovereign or government bonds issued by developing economies. Some of these sovereign bonds do not have strong credit ratings as they are perceived to be economically and politically less stable. In order to compensate debt holders for the higher credit risk that they are taking on, debt with lower credit ratings tends to promise higher yields (than bonds with better credit ratings). Along with the poorer credit ratings, many of these emerging market sovereign bonds are currently delivering much higher yields than that of developed countries.

Table 1: Sovereign Bond Ratings

Country

Standard & Poor's Rating

10-Yr Sovereign Bond Yield

United States

AAA

4.55%

United Kingdom

AAA

4.18%

Singapore

AAA

3.47%

Japan

AA-

1.59%

Emerging Market Bonds

Poland

A-

4.55%

Russia

BBB+

NA

Philippines

BB+

12.11%

Indonesia

BB

12.34%

Venezuela

BB-

6.50%

Argentina

B-

35.93%

Source: Standard & Poor's, Bloomberg
(Credit rating is as at 23 Feb 2006, the ratings are for local currency debt and yields are as at 1 March 2006)

Table 1 shows the list of sovereign bond ratings by Standard & Poor’s and the current yields of the 10-year sovereign bonds. This table shows that the yield of the 10-year sovereign bonds of emerging market countries (including Philippines, Venezuela, Indonesia, Argentina etc.) tend to be higher than the bonds of the more developed markets such as US, UK, Singapore and Japan. Generally, a higher yield tends to reflect a weaker credit rating. For example, Argentina has a credit rating of B- and underlying Sovereign 10-year benchmark bond has a yield of about 36%.

Funds investing in emerging market bonds do stand to benefit from the higher yield. A yield to maturity is the annual return that a fund manager can get if he purchases a bond and holds the bond to maturity. Thus, by holding the bond to maturity the fund manager can potentially earn a strong annual return (that is provided that the country did not default in its coupon and principal payments). In contrast, global bond funds tend to invest more into bonds with good credit ratings (investment grade and above) and yields from these bonds are generally lower than that of emerging market bonds.

Better Credit Ratings, Low Correlation With Global Equities

Aside from the higher yields garnered by emerging market bonds, there are also opportunities for some of these emerging market sovereign bonds to be re-rated. A country’s credit rating gets re-rated when the country showed improvements in carrying out monetary and fiscal policies that are likely to benefit the country’s credit position. Other reasons that may prompt the credit rating companies to up the ratings include, greater political stability, reduction in government deficit and better balance sheet positions etc. In the past few years, there has been a stark improvement in the political stability and economic growth of some of these emerging markets. (Click here for a report on emerging markets.) Recently, there were some re-ratings as there has been an improvement in monetary and fiscal stability in selected emerging countries. Emerging economies such as Russia and Poland were recently placed in the investment grade credit rating category (which is better than BBB- for S&P or Ba for Moody’s).

A case in point is Russia, which enjoyed a credit re-rating in Dec 2005. Russia has been experiencing strong improvements in their debt position since the nation defaulted on US$40 billion in domestic debt in 1998. In 2005, being the world’s second largest oil producer, Russia has generally benefited from a surge in oil prices to pay off creditors and set up a windfall fund (‘oil reserve fund’) to park the revenues gained from oil sales. S&P is the credit agency that upgraded Russia’s rating. According to the agency, Russia’s total state debt will reach US$119 billion or about 15% of the economy as at end 2005. This contrasts to the US$180 billion in foreign currency reserves according to a Bloomberg report dated 15 Dec 2005. S&P added that prudent management of oil revenue resulted in an accumulation of funds at a much faster rate than expected, creating a sizable safeguard for the coming years.

How do these credit re-ratings benefit emerging market bonds? When these bonds are re-rated (for example from below investment grade to above investment grade), there is a likelihood that the demand for these bonds will go up, thus pulling up the price of these bonds. In effect, there is a likelihood that capital appreciation will occur as the demand for these bonds strengthens.

Chart 1: Performance of Global Equities & Global Emerging Market Bond Index


Source: Bloomberg, MSCI

Another point to note is that being a distinct asset class, emerging market bonds have a low correlation with global equities. Price correlation between the MSCI World index and the emerging market bond index is low at 0.1. Correlation is the measure of how two indices move in tandem with each other. The red arrows in chart 1 show that there were periods that the indices moved in different directions from each other.A low correlation with global equities generally means that funds that invest in the emerging market bond actually adds to portfolio diversification for a global equity funds portfolio.

New GEM Onboard – ABN AMRO Global Emerging Bond Fund

Currently, we have three emerging market bond funds including the UOB United Global Emerging Market Portfolios, Schroder Emerging Market Bond Fund and the PIMCO Emerging Market Bond Fund. Recently, we brought onboard a new emerging market bond fund – the ABN AMRO Global Emerging Market Bond Fund. This fund has shown strong consistency in its performance since its inception (May 1998) and has constantly outperformed its benchmark index, the JP Morgan EMBI Global Index . Table 2 shows the performance of the fund over periods of up to 5 years. The ABN AMRO Emerging Market Bond Fund USD has outperformed in all these periods, while the UOB United Global Emerging Markets Portfolio S$ came in second. The 5-year annualized return for the ABN fund was 16.8% (as at end Jan 2006) and that is stronger than that of the index, which had an annualized return of 9.9% over the same period.

Table 2: Annualized Offer-to-bid Return of GEM Bond Funds (as at end Jan 2006 and in SGD)

Fund Name

1 year

2 years

3 years

4 years

5 years

PIMCO Emerging Market Bond USD

5.0%

5.9%

NA

NA

NA

Schroder Emerging Markets Bond Fund

-3.7%

2.1%

NA

NA

NA

UOB United Global Emerging Mkts Portfolios S$

9.0%

9.1%

16.2%

13.2%

NA

ABN AMRO Emerging Market Bond Fund (USD)*

14.5%

12.1%

20.4%

17.0%

16.8%

Source: Bloomberg, Fundsupermart Compilations
Performance figures are as at end January 2006, in SGD terms, annualized and calculated using offer-to-bid prices (based on 5% common sales charge), with any income or dividends reinvested. *Please note that there are is a EUR variation of this fund but we are taking the fund denominated in USD in this study, and we are presenting the performance in SGD so that it is a fair comparison when compared with its peers, which are denominated in SGD.

The ABN Emerging Market Bond Fund has two foreign currency tranches - the USD tranche and the EUR tranche. Both tranches invest into emerging market fixed income securities, primarily denominated in US dollars, with medium and long term maturity. According to the factsheet, the difference is that the EUR tranche is hedged to a large extent to the EUR currency. In our performance table, we are using the performances of the USD version of the fund (in SGD terms) as it has a longer track record. The USD version was incepted in 27 May 1998, while the EUR version was only incepted in 5 June 2003.

Chart 2 also shows that the ABN AMRO Emerging Market Bond fund outperformed its benchmark index (JP Morgan EMBI Global) by a large margin in the time period shown.

Chart 2: New Fund outperforms Benchmark


Source: Bloomberg (Prices are in SGD and rebased to 100 on January 2000)

Aside from the strong performance, the ABN AMRO Emerging Market Bond Fund also has another advantage. The management fee for the fund is the lowest among the GEM bond funds that we distribute. The average management fee for funds in this category is about 1.49%, but the management fee for this fund is only 1.25%. The ABN AMRO fund also has no outperformance fee, unlike the UOB United GEMS Portfolios which has a performance fee of 25% of excess return above 12% compounded return.

Table 3: Comparison of Management Fee

Fund Name

Management Fee

PIMCO Emerging Market Bond USD

1.45%

Schroder Emerging Markets Bond Fund

1.50%

UOB United Global Emerging Mkts Portfolios S$*

1.75%

ABN AMRO Emerging Market Bond Fund

1.25%

Source: Factsheet from various fund houses (PIMCO, Schroder, UOB Asset Management, ABN AMRO)

On the asset allocation, the ABN AMRO Emerging Market Bond Fund has a high allocation to Latin American bonds, particularly Venezuela sovereign bonds and Argentina sovereign bonds, with an allocation of 25.4% and 35% respectively. As at end Jan 2006, about 40% of the bonds invested are in the BB- category and 35% are in the B- category. In all only 15% of the bonds are in the BBB and above (or investment grade) category. Thus, this fund is skewed towards the non-investment grade fixed income investments, which typically deliver higher yield. The estimated yield-to-redemption of 7.84% (as shown in the factsheet of the fund as at end Jan 2006)), is reflective of the inclination in investing into higher yielding fixed income assets.

Chart 2: Geographical Breakdown of ABN Emerging Markets Bond Fund


Source: ABN AMRO (taken from fund factsheet as at 31 January 2006)

Conclusion

We think that Emerging Market bonds are suitable for investors who are interested to invest in fixed income funds, which are earning a better yield than the sovereign debt of developed markets. In addition to that, as these emerging market improve in terms of political and economic stability, there are also chances for further credit re-rating in some of the emerging markets. The 5-year annualized return for the JP Morgan EMBI Global Index is quite strong 9.9% (in SGD as at end Jan 2006). Another advantage of into this asset class is it has low correlation in comparison to, say, global equities. That means that it provides good diversification for an investor that already has global equities in his portfolio.

But a word of caution to investors - considering that this asset class has run up strongly, investors interested in investing in emerging market bond funds have to be prepared for volatility; it could be much higher than that of a generic global bond fund.

Those investors interested in investing in this asset class, should consider the ABN AMRO Emerging Market Bond Fund, which has been recently added to our stable of bond funds. This fund has delivered strong and consistent performance since its inception. We think it's a good choice for investors if they are thinking of investing in this unique asset class.

Fundsupermart currently have a promotion on the ABN AMRO Global Emerging Market Bond Fund click here to find out more.


Mah Ching Cheng (Senior Analyst, AFP & Investment Representative) is part of the Research and Editorial team at Fundsupermart, a division of iFAST Financial Pte Ltd.

This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any fund. No investment decision should be taken without first viewing a fund's prospectus. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Past performance and any forecast is not necessarily indicative of the future or likely performance of the fund. The value of units and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer