Japanese policymakers seem to be determined to pull the country out of the deflationary spiral. In the last few months, they have taken many aggressive measures to weaken the currency and stoke inflation, in order to reinvigorate the ailing economy.
Recently the Bank of Japan announced another round of unprecedented monetary easing measures—doubling its monthly debt purchases to about 7 trillion Yen and also lengthening the average maturity of its holdings to seven years from three years. (Read: DXJ-Best ETF to play the Japan Rally)
With the BOJ buying about 70% of JGBs issued every month and driving yields to ultra-level levels, Japanese institutions such as pension funds, banks and life insurance companies will be forced to invest in other assets that have similar risk but higher yields.
Japanese institutions generally prefer government bonds to riskier assets like stocks. Historically these institutions have been heavily invested in domestic bonds but recently they have been increasing their international holdings in search for yield and currency appreciation.
According to HSBC estimates, Japanese institutions’ purchases of international bonds could be close to a trillion dollars this year. German Bunds, French Oats and emerging markets government bonds are expected to benefit from these fund flows. (Read: 3 sector ETFs Surviving This Slump)
Among these, emerging markets sovereign bonds already have a strong investment case. Yield levels are still quite attractive in these countries and many central banks have the flexibility to cut interest rates further to stimulate growth, which would result in price appreciation.
On the other hand, yields on German and French sovereign debt are already at very low levels, leaving little scope for price appreciation.
Many emerging countries now have better fiscal health and lower debt levels than their developed counterparts. Healthy emerging economies also have adequate levels of foreign exchange reserves and deep and liquid financial markets. Credit quality and liquidity in emerging market debt have been improving over the past few years. (Read: MLP ETFs for Growth and Income)
Among emerging countries, Japanese investors have been showing a preference for sovereign debt of countries like Indonesia, Philippines, Turkey, Mexico and Brazil. Emerging Markets Sovereign Bond ETFs are set to benefit from massive fund flows from Japan.
Among the ETF plays available--investors can choose between the debt issued by the governments in US Dollars or in local currencies.
We may add that in general, emerging market currencies are more volatile than the U.S. Dollar and in times of global economic turmoil, the Dollar benefits from its “safe haven” status.
However, in the longer-term, the currencies of healthy developing economies are likely to outperform the Dollar.
In addition to greater return potential in the long-term, local currency denominated debt ETFs are less sensitive to interest rate changes compared with USD denominated debt ETFs due to their shorter duration (4-5 years) compared with the duration of two USD denominated emerging market debt ETFs (7-9 years). Further, they provide greater diversification benefits.
PowerShares Emerging Markets Sovereign Debt (PCY)
PCY is based on the DB Emerging Market USD Liquid Balanced Index, which tracks liquid emerging markets U.S. dollar-denominated government bonds issued by 22 emerging-market countries.
Launched in November 2007, the product has already attracted more than $2.6 billion in assets. It charges the investors 50 basis points in annual expenses and currently pays out a yield of 4.63%. Mexico, Indonesia, Brazil and Philippines are among the top countries allocations.
About 57% of the fund’s 67 holdings are currently investment grade rated. Effective duration of the fund is 9.51 years while Yield to maturity is 4.26%. This fund is suitable for investors who do not want short-term currency related fluctuations in their portfolio.
WisdomTree Emerging Markets Local Debt Fund (ELD)
ELD is actively managed and thus does not track a specific benchmark. Currently 83.1% of the assets are invested in sovereign bonds and 14.3% in supranational bonds.
The fund has more than $1.9 billion in AUM as of now. Current SEC yield is 3.82% while the expense ratio is 55 basis points per annum.
Mexico, Malaysia, Indonesia and Brazil occupy the top spots in terms of country exposure.
Effective duration of the fund is 4.83 years and its Yield to maturity is 4.47%. About 78% of the bonds are rated BBB or higher (investment grade rating).
Market Vectors EM Local Currency Bond ETF (EMLC)
EMLC tracks JP Morgan GBI-EMG Core Index that provides direct exposure to local currency bonds issued by emerging market governments. The fund pays out dividends on a monthly basis.
The ETF holds 213 securities, with an average modified duration of 4.99 years and average Yield to maturity of 5.15 years.
In terms of country exposure, Poland, Malaysia, South Africa and Brazil occupy the top spots.
The ETF charges expense ratio of 47 basis points, while the 12 month yield is 4.04% currently. 54.1% of the index holdings are rated investment grade by S&P.
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