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Dollar Dilemma for EM Bond ETFs

This article was originally published on ETFTrends.com.

The iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) and other exchange traded funds holding dollar-denominated emerging markets debt are struggling as familiar problems are weighing on these funds. Notably, the stronger dollar is pinching developing world debt.

EMB tracks the J.P. Morgan EMBI Global Core Index, a market-cap-weighted index. Potential investors should note that since it is a cap-weighted index, countries with greater debt will have a larger position in the portfolio. EMB is now the world’s largest emerging markets bond fund, ETF or mutual fund.

“The benefits of a weak dollar and rising commodity prices, which supported strong emerging-market (EM) growth in 2017, are now beginning to fade,” said Fitch Ratings in a recent note. “This will leave EM issuers facing more challenging economic and financial conditions as interest rates rise and central bank monetary policy becomes less accommodative.”

Comparing Monetary Policies Around the World

When comparing global central bank monetary policies, most developed countries have heavily relied on quantitative easing and low interest rates to bolster their economies, with some, notably the U.S. and the United Kingdom, already eyeing tighter monetary policies to obviate a potentially overheating economy. Meanwhile, many emerging market central banks have more room to run with their easing policies, which may continue to support their local debt securities.

Related: Short-Term Bond ETFs Play a Role in Any Environment

Mexico is the only major developing economy that has raised rates this year, but Brazil recently disappointed investors by not unveiling another rate cut. Both countries are among the largest geographic exposures in EMB.

“The US dollar had remained surprisingly weak after the Fed began its rate rise cycle in December 2015 but it has recently started to rise as Treasury yields hit 3% at the end of April. Some countries have therefore felt increasing pressure on their currencies, notably Argentina, Turkey and Brazil,” said Fitch.

Last year, inflows to emerging markets bond funds set an annual record. However, investors’ affinity for developing world debt could be challenged in 2018 amid a slew of elections that could spark increased political volatility.

“Defaults are down from the highs of 2016 and rating outlooks are evenly balanced between positive and negative across all major sectors. But there were significant net EM sovereign downgrades over 2014-2017, reflecting the drop in commodity prices as well as political and other idiosyncratic factors,” according to Fitch.

For more information on the fixed-income markets, visit our bond ETFs category.

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