Emerging market debt and bond-related exchange traded funds offer relatively attractive yields, but investors could see higher credit risk in so-called trouble spots as growth slows and rates rise.
According to the International Monetary Fund, as much as $750 billion emerging market corporate loans could be in trouble, and investors could see more defaults down the line.
“The share of corporate debt held by weak firms is even higher now than in the period following the September 2008 collapse of Lehman Brothers,” Moody’s said.
If growth continues to slow and interest rates rise in the emerging markets, the cost of servicing the debt will increase.
“This problem goes beyond corporate bonds and includes the broader increase of credit relative to G.D.P. in many emerging markets,” Hung Q. Tran, a top executive at the Institute of International Finance, said in a New York Times article. “Countries have to put in place policies to address this if they want to avoid a bursting of the bubble.”
As the emerging markets rebounded off the financial crisis, more smaller and more financially unstable companies have issued debt. For example, Brazilian issuers have received mixed views. [A Mixed Case for Some EM Bond ETFs]
The potential weakness could have a far reaching effect as more U.S. investors gain exposure to the market, with retail-oriented emerging market bond mutual funds expanding to $76 billion in assets from $12 billion since 2008, according to Thomson Reuters data. [Investors Want Emerging Market Bond ETFs]
“Many of the funds that are buying these companies don’t even know what they are buying,” Elizabeth R. Morrissey of Kleiman International Consultants said in the article. “All of a sudden, we have Joe Middle Class loading up on emerging-market bond E.T.F.s. That is a little frightening.”
Like with all investments, investors should understand how an ETF works before jumping in. For instance, the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) and PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) provide exposure to U.S. dollar-denominated emerging market debt. Alternatively, the actively managed WisdomTree Emerging Markets Local Debt Fund (ELD) and the passively managed Market Vectors Emerging Markets Local Currency Bond ETF (EMLC) for exposure to local currency denominated debt.
For more information on developing countries, visit our emerging markets category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.