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Choices For Emerging Market Bond ETFs

Clayton Fresk

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Clayton Fresk, CFA, portfolio management analyst at Georgia-based Stadion Money Management.

The talk of higher interest rates here in the U.S. is seemingly on the forefront of most market participants’ minds. This, combined with the still-anemic interest-rate environment in which we currently reside, has investors looking for alternate sources of income.

There has been much talk about stepping down in quality here in the U.S. via high-yield bonds. Another route that has been discussed is diversifying outside of U.S. fixed income. While developed-market exposure is an option, in the following, I will look at various emerging market bond exposures available in ETF form.

USD-Denominated Sovereign

The most popular way ETF investors currently access emerging market bonds (solely based on assets under management) is via dollar-denominated sovereign debt. The three most prevalent names in that space (with performance through Nov. 10) are:

While not exactly the same, the iShares J.P. Morgan USD Emerging Markets Bond (EMB | B-58) and the Vanguard Emerging Markets Government Bond (VWOB | B-34) are more similar to one another than the PowerShares Emerging Markets Sovereign Debt (PCY | B-60). One differential is that VWOB follows an issuer-capped index, so it will have lower exposure to the largest EM issuers (China, Russia, Mexico and Brazil) as compared with EMB.

However, PCY differs from the other two in that it uses a balanced index. The fund currently has equal-weight exposure to 28 different EM countries (which currently excludes China). Using the indexes for PCY (DBLQBLTR) and EMB (JPEICORE), here is a comparison of return and risk since March 1999:

As you can see, the index for PCY has a greater return (and the fund currently has a slightly higher yield than EMB and VWOB), with the trade-off being a bit higher risk as measured by both standard deviation and maximum drawdown.

Local Currency Sovereign

For some investors, the appeal of investing outside of the U.S. is to capture the currency effects of these bonds. While the aforementioned ETFs do not have the currency effect, as they are USD-denominated issues, there is a plethora of local EM bond ETFs available. Additionally, investing in entities that can issue in local currency rather than in dollar-denominated bonds opens an investor up to a different set of issuer qualities.

Here is a list of local EM bond ETFs, again, with performance through Nov. 10:

As illustrated by the YTD performance column, there is not a significant amount of dispersion between these names. Here is a breakdown of allocation percentage by country:

While, for the most part, the country exposures do not vary, there are a few exceptions. The one that sticks out is South Korea. Due to differing index methodologies in emerging versus developed classifications, the iShares Emerging Markets Local Currency Bond (LEMB | C-91) has more than 20 percent exposure, while the Market Vectors J.P. Morgan EM Local Currency Bond (EMLC | C-54) and the First Trust Emerging Markets Local Currency Bond (FEMB | F) have no exposure.

As I mentioned above, a major difference in these names is the currency exposure as compared to the dollar-denominated ETFs. Additionally, the issuer exposure is also different. As such, if there were a currency-hedged local bond ETF, it would not have the same characteristics as a USD-denominated ETF.

Using the index for the SPDR Barclays Emerging Markets Local Bond (EBND | D-87) as an example, here is the local versus hedged YTD performance as compared to the same USD-denominated EMB index used above:

Dollar-Denominated Corporates

Stepping back into the dollar-denominated area, another option for investors is corporate debt versus sovereign debt. ETFs available to invest in corporate debt are:

To illustrate the corporate versus sovereign decision, here are some side-by-side comparisons of the different ETFs versus EMB:

While the yields are somewhat similar, there is a bit of a trade-off of accepting more spread risk in corporates while also getting a bit lower duration. Additionally, the top country exposure is more concentrated (similar to local currency sovereigns).

Conclusion

When looking to emerging market bonds as an alternative to U.S. or developed-market exposure, there are various ETFs to choose from. An investor just needs to decide what type of issuer exposure they are comfortable with, whether it is sovereign or corporate, and dollar versus local denominated.

At the time of writing, the author’s firm held no shares of any of the securities mentioned. The above constitutes the personal, professional opinion of Clayton Fresk, CFA, and does not reflect the views of Stadion Money Management LLC. References to specific securities or market indexes are not intended as specific investment advice. Founded in 1993, Stadion Money Management is a privately owned money management firm based near Athens, Georgia. Via its unique approach and suite of nontraditional strategies with a defensive bias, Stadion seeks to help investors—through advisors or retirement plans—protect and grow their “serious money.” Contact Stadion at 800-222-7636 or www.stadionmoney.com.

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