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Emerging Market ETFs in Trouble on Stronger Dollar?

Zacks Equity Research

With the U.S. economy appearing stronger from Q2 of this year, many investors turned their focus to the domestic market. This trend isn’t limited to the equity world either, as long-term Treasury securities have also seen solid inflows this year which can satisfy investors’ need for relatively better yield and capital appreciation.

The rush toward high-yield long-term treasuries became more prevalent on consistent upbeat economic data leasing to ripe speculation of sooner-than-expected policy tightening.  Meanwhile, the Fed is likely to fully close its QE program next month pushing the U.S. dollar to the six-year highs against the yen (read: 3 Excellent ETFs to Play the Dollar Surge).

However, these incidents have infused concerns about many developed and emerging markets around the globe. Investors target emerging market bond ETFs in search of higher yields. While taper talks ravaged the emerging market asset classes last year owing to the panic selling spurred by fears over the cease in cheap dollar inflows, the repetition of the same episode is less likely this year.

This was more true since the emerging market assets are undervalued now hinting that the sell-off is overdone. After all, thanks to the recent run-up long-term U.S. treasuries, yields fell considerably since the start of the year.

This will likely push some investors toward typically high-yield emerging market bond and currency ETF space.  Notably, yield on 10-year U.S. treasuries stands at 2.62% (as of September 17, 2014).

Impact on Emerging Market Currency

Having said this, we expect certain erosion in the emerging market currencies. This can be validated by the 2% fall in Dreyfus Emerging Currency Fund (CEW) in the last one month (as of September 17, 2014).

The fund’s embedded income yield – which measures the annualized rate of return generated by a fund's investments in both fixed income securities and derivatives exclusive of interest rate changes and translation in foreign exchange spot rates (as per WisdomTree definition) – stands at 4.58% as of September 17, 2014 (read: Where Will Global Currency ETFs Go in 2014?).

In fact, embedded income yield is higher at Brazil and India currency ETFs. BZF and ICN currently carry embedded income yield of 9.54% and 6.15%. These two ETFs have Zacks ETF Ranks of Strong Sell, though we expect price declines to be less than last year.

Target Dollar-denominated EM bond ETFs

Coming to bond ETFs, emerging markets still offer some opportunities. Investors should note that emerging markets debt profile is more stable than the developed markets. The government debt to GDP ratio of Turkey, Brazil, India, Mexico, Philippines and Indonesia stood, respectively, at 35.85%, 56.8%, 67.72%, 36.90% and 26.11% in 2013 while the same ratio for the U.S. remained at 101.53% in 2013.

Interest rates are quite high in emerging markets compared to the U.S. The key interest rates at Turkey, Brazil and India remain at 8.25%, 11% and 8%, respectively, while in the U.S. it is 0.25% though hikes are likely next year (read: Can Rate Hikes Save these Emerging Market ETFs?).

Higher rates normally attract foreign investors to fixed income investments which in turn will boost the value of the currency. Still, investors seeking to play the fixed income space of the emerging markets might look at dollar-denominated bond ETFs. However, investors might see a curtailed value on repatriation of overseas assets.

Still, we highlight below a few choices which might be worth considering for yield-hungry investors though an interest rate hike in the U.S. next year will mar the high-yield appeal of these products (read: Van Eck Plans Emerging Market Bond ETF for Higher Yields).

Market Impact

Over the past one month, Emerging Markets Corporate Bond Fund (CEMB) having the maximum focus (17.8%) on Brazil and Mexico (about 11.6%) has shed about 0.3%. This dollar-denominated ETF targets a short-duration profile. The fund has a Zacks ETF Rank #5 (Strong Sell) with a high risk outlook. CEMB is up 5.5% year to date.

Another option is iShares Emerging Markets USD Bond ETF (EMB) which looks to track the bond markets of more than 10 nations. Turkey gets the highest exposure with 5.7% followed by Mexico (5.5%) and Brazil (5.5%).

Poland gets the least weight with 3.7%. The fund’s holdings had a weighted average life of 7.2 years and yields (ttm) of 4.29% (as of September 11, 2014). EMB has gained about 5% so far this year but shed about 1.3% in the past one month.

Yet another choice is PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) which has almost equal exposure to about 22 countries. Credit exposure is heavily skewed toward the ‘BBB’ level so there is some risk there.

Effective duration of the fund is 9.10 years indicating moderate interest rate risk. The 12-month yield of the fund stands at 4.37%. PCY is up 6.3% year to date and has lost about 1.7% in the last one month. 

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