Building a diversified income strategy with emerging markets

Pacific Investment Management (PIMCO) released an informative strategy paper recently outlining the environment for credit products and a diversified income strategy.

Image courtesy Christopher:

A busy day at Xiang Yang Market in downtown Shanghai.

The paper was focused on income from bond investments but the insight is appropriate for positioning in equity markets as well. Combined with Bill Gross’ investment outlook released in March, investors are being advised to position for increased systemic risk and a focus on income in relatively safer markets.

Higher debt levels and population dynamics mean that growth in developed markets will remain below potential. Debt levels across these markets have brought austerity measures but because of significant liquidity by central banks, yields on debt are being held down. As risks remain high but yields are unattractively low, investors have shifted the ‘safe’ portion of their portfolio into emerging markets. The emerging markets have much stronger balance sheets with lower debt ratios and higher growth to avoid default.

The PowerShares Emerging Markets Sovereign Debt (PCY, quote) provides investors with exposure to dollar-denominated debt from emerging market governments. The fund pays a dividend yield of 5.2% and will give investors the benefit of higher yields from EM debt, but should be less volatile due to its dollar-base.

The WisdomTree Emerging Markets Local Debt (ELD, quote) invests in local currency debt in emerging markets. The fund pays a dividend yield of 4.1% but may outperform the dollar-denominated fund as emerging market currencies appreciate over the long-term.

Besides the shift to emerging market debt, investors are also transitioning their portfolios from sovereign to corporate debt. While this exposes the investor to default risk, not usually a problem with sovereign issues, many corporations are carrying a significant amount of cash on their balance sheets and have deleveraged over the past few years.

The WisdomTree Emerging Markets Corporate Fund (EMCB, quote) was launched in May, giving investors exposure to the rapidly growing sector of EM corporate debt. The fund is fairly diversified with exposure to corporate debt in Latin America (51.5%), Asia (23.9%) and EMEA (24.6%) and sector exposure in energy (35.7%), industrials (19.8%), metals (19.6%) and telecom (12.6%). The fund has not yet distributed a dividend but the embedded income yield is 5.3% with a 6.0% weighted average coupon for debt held.

The SPDR Barclays Capital Long Corporate Fund (LWC, quote) provides exposure to long-term debt by U.S. corporate issuers. Companies based in the United States have historically high amounts of cash on their balance sheets and should benefit from a recovery, albeit slow, in the domestic market. The fund pays a dividend yield of 5.0% and helps to diversify a portfolio when added to the more volatile emerging market debt funds.

Hedging for Inflation

The extreme amount of liquidity being forced into the system by central banks in developed markets has not yet driven prices up considerably. Sluggish economic growth and uncertainty have caused banks and corporations to sit on excess cash rather than investing it so the velocity of money, the culprit behind inflation-induced liquidity, has not taken hold.

Slowing growth in China and the developed markets has caused many emerging market central banks – notably China and Brazil, to institute some fairly aggressive stimulus measures themselves. Brazil recently changed banking regulations to allow the central bank to further lower rates without driving investors out of bonds and into savings accounts. While these stimulus measures have also not yet stoked pricing pressures, for largely the same reasons as above, the fear is that authorities will not act quickly enough in raising rates when inflation starts to increase.

While a few central banks may be sufficiently proactive to withdraw liquidity before inflation threatens, the breadth of stimulus across the developed and emerging markets leads me to believe that swift and coordinated restriction of the money supply will not be implemented. This will lead to increasing inflation through almost all markets within about 18-24 months.

Because fixed-income products cannot compete during periods of increasing inflation, investors will want to protect themselves with investments in hard-assets and other inflation-protected assets. A portion of investable assets in various commodity and real estate funds would provide a level of protection and diversification. Possible candidates include the PowerShares DB Agriculture (DBA, quote), SPDR Gold Shares (GLD, quote), and the Vanguard REIT Index (VNQ, quote).