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A Bond ETF Idea Using Local Currencies For 2018

ETF Professor

Fixed-income exchange traded funds are on a blistering pace of asset gathering in 2017, having shattered previous inflows records. Several of this year's top 10 asset-gathering ETFs are bond funds. While it remains to be seen if that scenario will repeat in 2018, some corners of the bond market can build on solid 2017 performances next year.

With investors continuing to search for additional income and yield at a time when interest rates remain low throughout the developed world, emerging markets bonds denominated in local currencies could again deliver for investors in 2018.

That would be good news for the VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (NYSE: EMLC). EMLC is alluring to income investors with a 30-day SEC yield of 5.75 percent, which is well above what investors find in 10-year Treasuries. Additionally, EMLC is up 7 percent this year while major aggregate bond benchmarks are up less than 1 percent.

A Repeat Performance

“Emerging markets local currency sovereign bonds will likely be one of the best-performing fixed income asset classes in 2017 based on year-to-date performance,” said VanEck. “Similar to 2016, returns have been driven primarily by local interest rates rather than foreign currency, and we expect the same dynamic to play out in 2018. Generally stable or improving fundamentals in emerging markets and global growth will, in our view, likely provide support against higher interest rates in developed markets.”

Bonds denominated in local currencies are vulnerable to a stronger dollar, but if the greenback bounces back in 2018, many market observers believe those increases will be gradual. Interestingly, the U.S. Dollar Index has traded slightly lower since the most recent interest rate hike by the Federal Reserve earlier this month. The U.S. Dollar Index is lower by more than 8 percent this year.

The $4.6-billion EMLC holds 265 bonds. About three-quarters of the ETF's holdings are rated A, BBB or BB.

Market-To-Market Impact

EMLC features exposure to nearly 20 countries and bonds denominated in 18 different emerging currencies.

Brazil and South Africa combine for almost 17 percent of EMLC's geographic exposure.

In Brazil, politics have been plagued by scandals and kept structural reforms on the backburner, according to VanEck. The Brazilian economy is beginning to show signs of growth, meaning it's time for progress in achieving reforms in the South American country, the firm said.

South Africa "is among the weakest countries in the J.P. Morgan GBI-EM Global Core Index from a fiscal and economic perspective, which is reflected in its deteriorating credit ratings," according to VanEck.

"The recent election of Cyril Ramaphosa as leader of the ruling party is a strong signal of progress, but executing needed reforms may be challenging and take time.”

The good news is that in 2017, only one emerging market, Mexico, raised interest rates. It is likely a similarly low number of developing economies will do the same next year.

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