“Fifteen years ago, Goldman Sachs brought emerging markets back into vogue,” Jonathan Lemco, a senior investment strategist with Vanguard Investment Strategy Group, said, “by predicting growing populations and maturing economies.” While a famous 2001 policy paper1 focused on four countries (Brazil, Russia, India, China), more developing countries now have larger currency reserves, adequate debt metrics, reasonably stable political systems, and rising middle classes. These developments have created a favorable environment for bond buyers, Mr. Lemco said.

“Investors should understand that many of these countries are not the economic basket cases they once were,” Mr. Lemco said. “The quality of life for people in these countries, with some exceptions, has never been this good.”


How relevant are the BRICS?

Emerging markets fell into investor disfavor in the late 1990s and early 2000s, when appreciation in the U.S. dollar and falling commodity prices provided the backdrop for financial crises in several countries. Those crises forced many countries to break their hard currency pegs to the dollar.

In 2001, Goldman Sachs brought emerging markets back to the fore when it published a policy paper about how four emerging markets countries were poised to see an explosion in their populations and gross domestic products (GDPs). Those countries—Brazil, Russia, India, and China—should be given a greater voice in world policymaking forums such as the G7, argued author Jim O’Neill, then head of Goldman’s global economic research.1

That paper coined the term BRIC. South Africa was later added to complete the acronym, and the five countries became an investing theme.

Mr. Lemco said that focusing on five countries never made as much sense as looking at the broader emerging markets. Although BRICS joined world policy-making bodies and the countries did open a development bank in 2015, the five have never had much in common.

“Beyond the fact that they’re enormous and important, there’s nothing that should cause you to believe they’re in any way united,” Mr. Lemco said. “We probably never should have considered them more than an acronym, since there’s not much utility tying them together. Why not include Mexico, Turkey, or Indonesia?”

Nonetheless, the long-term demographic and economic trends that Mr. O’Neill identified have played out, Mr. Lemco said. Most emerging markets countries now have lower sovereign debt–to–GDP ratios (the amount of debt a national government issues in a foreign currency in relation to its gross domestic product) than during the 1990s. The nations that have increased their debt loads owed to foreign creditors have been able to do so through deepening domestic financial markets and better access to private sector funding.

Mr. Lemco pointed to Mexico as an example of a country that has seen enormous progress.

“Mexico is an investor darling right now,” he said. “Pemex, the former national oil company, comes to the market fairly regularly and tends to be attractively priced. Mexico sovereign bonds are liquid, and the country is now politically and fiscally well-managed. Economic growth will be okay because it’s tied to the United States.”

Mexico is not alone, he added.

“China has elevated hundreds of millions of people to the lower middle class in the last 25 years,” Mr. Lemco said. “Other countries in the region, like India, have also seen meaningful improvements, such as a larger and growing middle class. Indonesia and South Korea are also good examples of that.” He noted that South Korea now has the tenth-largest GDP in the world, according to the Organisation for Economic Co-operation and Development.2


Opportunities in bonds

Mr. Lemco said sovereign and corporate bonds in emerging markets present investment-grade3 opportunities for active bond managers and investors and are a way to invest in the economic and financial futures of these countries. The bonds of fiscally well-managed developing countries have relatively attractive yields. Meanwhile, countries with fiscal and political issues, such as junk-rated Brazil, must offer higher yields to compensate investors for the added risk.

Vanguard invests in emerging markets bonds in the actively managed Vanguard Short-Term Investment-Grade, Vanguard Intermediate-Term Investment-Grade, and Vanguard Long-Term Investment-Grade Funds, as well as various index funds, including the Vanguard Emerging Markets Government Bond Index Fund.

“Vanguard believes in fundamentals—in combining our best economic, political, and financial knowledge,” Mr. Lemco said. “On balance, we’ve seen a major improvement in emerging markets. It’s a risk-reward balance. Given the economic and political risk for these countries, are we being appropriately compensated for that risk? That’s the kind of judgment call we make every day.”

But even if a country’s bonds look attractive from a fundamental perspective, technical factors must be considered as well, he said.

“Our traders may tell us, ‘Yes, we like the credit, but there’s no liquidity.’ Or they may say, ‘The new bond issue came in, and, yes, we like the country, but it was not attractively priced.’ We work together, hand in hand, our traders and our analysts, all the time,” he said.

Investors should remember that active outperformance can take time, Mr. Lemco added. Vanguard research has shown that the odds of investor success in active management can be improved with top talent, low cost, and patience.4

1Jim O’Neill, 2001. Building better global economic BRICs. London: Goldman Sachs. (Global Economics Paper No: 66).
2Organisation of Economic Co-operation and Development, 2014. Gross domestic product expressed in millions of U.S. dollars, current prices, and constant prices. Accessed on February 29, 2016: http://stats.oecd.org/Index.aspx?DataSetCode=SNA_TABLE1.
3Investment-grade bonds include U.S. Treasuries and other fixed income securities with a credit rating of Baa3 or higher by Moody’s or a credit rating of BBB– or higher by Standard & Poor’s or Fitch.
4Daniel W. Wallick, Brian R. Wimmer, and James Balsamo, 2015. Keys to improving the odds of active management success. Valley Forge, Pa.: The Vanguard Group.

Notes:
Past performance is no guarantee of future returns.

All investments are subject to risk, including the possible loss of the money you invest.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

The Emerging Markets Government Bond Fund is subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments. The Fund seeks to track the performance of an index that measures the investment return of dollar-denominated bonds issued by governments of emerging market countries (including government agencies and government-owned corporations). Because the Fund invests only in U.S. dollar-denominated bonds, U.S.-based shareholders are not subject to currency risk, although if an issuer’s home currency declines relative to the U.S. dollar, it could negatively affect perceptions of the issuer’s ability to make payments, which could cause the issuer’s bonds to decline in value.

The Emerging Markets Government Bond Fund is subject to risks including country/regional risk, which is the chance that political upheaval, financial troubles, or natural disasters will adversely affect the value of securities issued by foreign governments, and emerging market risk, which is the chance that bonds of governments located in emerging markets will be substantially more volatile and substantially less liquid than the bonds of governments located in more developed foreign markets.