News Analysis date published New: 
Tuesday, July 31, 2012 - 10:00
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Tuesday, July 31, 2012 - 15:23
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Tuesday, July 31, 2012 - 10:00

The Best Way to Play the Next 30-Year Bond Rally

Tuesday, July 31, 2012 10:00 AM

Buying Treasury bonds in 1982 turned out to be a historic investment that produced huge gains during the next 30 years. And right now, history is repeating itself.

Back in 1982, the United States was struggling under the weight of high interest rates after years of slow growth and high inflation. But during the next 30 years, as the country shifted into a secular growth trend, interest rates steadily fell, pushing bond prices higher and producing huge gains for anyone buying ahead of the big turn in the market.

Treasury bonds monthly chart (1978-present)

Treasury Bonds Monthly Chart 1978-Present

If you missed that historic move, then there's no need to worry, because that same cycle is about to repeat itself in another part of the world.

Emerging-market bonds remind me of Treasuries back in 1982. Just like the United States three decades ago, these smaller, less developed economies are on the front end of a long-term growth trajectory that will strengthen their financial profiles and push interest rates lower.

Take Brazil, for example. After many years of higher growth rates than developed economies, rating agency Fitch just affirmed the country’s “BBB” credit score, citing “strong external balance sheet metrics, a diversified and high value-added economic base, a well-capitalized banking system and consensus on the main thrust of economic policies,” as driving factors. Looking forward, Fitch said it expects Brazil’s fundamentals to remain strong in spite of ongoing global economic volatility, and raised its 2013 growth projection to 4.5% from 2.5%.

That story is largely the same across a number of countries and regions, including Vietnam, South Korea and the Philippines, all of which are enjoying outsized economic gains that move their bond ratings closer to investment grade.

But there is also the risk, and even investment restrictions, that come with investing in the bonds of an individual emerging market like Brazil or China. Limiting exposure to any individual emerging-market growth story is a great way to diversify and reduce risk.

That’s why my favorite way to invest in emerging-market bonds is with the PowerShares Emerging Markets Sovereign Debt (NYSE: PCY) exchange-traded fund (ETF). This fund is designed to correspond to the price and yield of the DB Emerging Market USD Liquid Balanced Index, an index of emerging-market bonds with 65 holdings. The regions represented in this index span emerging markets across the globe, including Latin America, Eastern Europe and Asia Pacific. Individual countries include Vietnam, Columbia, Peru and Lithuania.

This is a fairly well-known fund in the emerging-market bond space, with assets valued at more than $1 billion. This has lifted average daily volume to 688,000 shares, providing plenty of liquidity for individual and institutional investors. It has also helped produce a tight bid-ask spread that will help investors get strong price execution and avoid slippage.

In terms of fees, this fund is cheaper than its nearest competitor and in line with its category average of 0.5%. Index funds usually have lower expense ratios than actively-managed funds, because of less turnover and lower execution fees and administration costs.

Risks to Consider: Emerging markets are more volatile than developed economies and are more vulnerable to general economic conditions. During times of economic stress, investors flock to more conservative segments of the market like Treasuries and large-cap dividend stocks. Although this isn’t happening yet, further economic volatility and weakness in Europe could push investors out of emerging-market assets.

Action to Take --> Emerging markets will be more volatile than developed economies like Japan and the United States. But longer term, just like small-cap stocks, these markets are poised for outsized growth. This could reduce the group’s cost of borrowing, sending bond prices skyrocketing and enabling current investors to lock in a sold 5% yield in a low-yield environment. This is why PCY is a great buy.

Michael Vodicka does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.