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Emerging Market Local Debt ETFs Shine

Cinthia Murphy

Emerging market bond ETFs denominated in local currencies are among the best-performing fixed-income ETFs year-to-date.

They’ve come a long way from the massive hit they faced last November when the U.S. elected Trump as the new president. That sell-off then centered on renewed concerns about inflation, higher rates and a strong dollar under the new administration.

And many of these concerns remain in place. Asset management giant BlackRock’s most recent market commentary included the following about emerging market bonds:

We maintain a neutral position on emerging market bonds. While we do maintain a long-term constructive view on EM debt based upon the global reflationary trend, significant risks remain, particularly the potential for rising global rates, a stronger dollar and the introduction of policies that would negatively impact global trade, hence our near-term neutral stance on the asset class.”

But nearly five months after the election, these ETFs are leading fixed-income funds with strong performance. So far in 2017, they are among the best-performing funds among all fixed-income ETFs. Consider the chart below plotting the five best-performing EM bond ETFs year-to-date:

Chart courtesy of StockCharts.com

 

Investors Largely Underweight

These funds’ performance stand out relative to the returns seen in the iShares Core U.S. Aggregate Bond ETF (AGG), which is up only 0.7% in the same period, and the iShares 20+ Year Treasury Bond ETF (TLT), up 1.7% to-date in 2017.

To someone like Mark Dow, founder of Dow Global Advisors, that’s no surprise, even if most investors seem to missing out on the move, remaining largely underweight the segment.

Dow, whose experience includes roles as a policymaker, investor and trader focused on global macro and emerging markets, has been making a case for emerging market local currency bond investing for a long time.

And here’s why. According to him, there’s still no significant growth in emerging market economies to speak of; there’s no real earnings power behind the little growth we’ve seen. But emerging markets are in an ongoing bottoming process, and EM currencies seem to have already “bombed out.”

“The great thing about local currency sovereign bonds is that they have a really nice yield,” Dow recently said. “And if you think the currency has taken its biggest hit, it's going to be hard for the currency to depreciate more than the yield you're getting from those bonds.”

With EM local currency sovereign bond ETFs, “you get good yield and you're not taking credit risk,” he said.

Asset Flows Still Lagging

Still, asset inflows into the segment remain small year-to-date. EBND, for example, has seen zero net asset inflows so far in 2017. FEMB and LEMB have seen a combined $13 million in net creations year-to-date, while ELD has attracted $14 million.

The exception here is EMLC, which has seen net inflows of $338 million so far this year, with a lot of those assets coming early in the year. But EMLC is the largest local-currency EM bond ETF, with $2.8 billion in total assets.

It could be that investors are still afraid of what higher rates and a strong dollar could do to emerging markets in general—the same type of concern that has BlackRock neutral on the segment.

However, according to Dow, a clearer view of U.S. rate policy—where it’s headed—is the first step in allowing emerging market fundamentals to improve. And we are getting just that, a clearer picture. A rapid rise in rates would hurt the region, but that doesn’t seem to be what the Federal Reserve has in store.

 

Weakening Dollar Helps

The other good news for emerging markets is the fact that the dollar has given up ground recently, not strengthened—the greenback has declined nearly 3% year-to-date.

As Research Affiliates wrote in 2015, there are three key truths about emerging markets as they relate to developed markets, and more specifically, the dollar:

  • A better economic outlook and higher yields in the United States have been typically followed by stronger growth, rising risk appetites, and capital inflows in emerging economies.
  • A strong dollar is not the cause of emerging market struggles. Quite the contrary: a strong dollar is result of an adjustment process that, historically, has fed their economic recovery.
  • Emerging markets are a heterogeneous group of countries that over the years have built significantly larger reserves and a domestic debt market. Hence, the likelihood of observing widespread currency and banking crises has decreased.

Differences In Exposure

These ETFs offer access to sovereign debt from some of the largest emerging market economies—many of which have strong domestic consumer-driven demand as well as positive commodity-export stories. Here’s a quick overview of what you get with each of these five portfolios:

VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (EMLC)

EMLC, which allocates across some 20 emerging markets, tracks an index that has Mexico and Brazil as its largest currency exposure, at about 20% of the mix. So far this year, the Mexican peso is up 8%, while the Brazilian real is up 5%. EMLC, the largest of the bunch, costs 0.47% in expense ratio—somewhere in the middle range for this segment. The fund, with some 247 holdings, has a 30-day yield of 5.8% and is up 6.43% this year.

First Trust Emerging Markets Local Currency Bond ETF (FEMB)

FEMB, the best-performing of the group, with a 6.89% return so far this year, is also the most expensive, with a 0.85% expense ratio, and is the smallest among these five ETFs, with $25 million in assets. The fund is also actively managed, unlike most of its counterparts. FEMB, which owns a broad range of sovereign bonds, currently has a 30-day yield of 5.0%. FEMB’s largest country allocation is Brazil, at nearly 15% of the fund.

 

iShares Emerging Markets Local Currency Bond ETF (LEMB)

LEMB, with $319 million in assets and 200 holdings, tracks a market-value-weighted index of sovereign bonds. The fund has a 30-day yield of 4.5%. With an expense ratio of 0.50%, LEMB holds South Korea, Brazil and Mexico at the top, together representing about 40% of the portfolio. The South Korean won is up 6.8% year-to-date. The fund is up 6.73% year-to-date.

WisdomTree Emerging Markets Local Debt Fund (ELD)

ELD, with $249 million in assets, is also actively managed, like FEMB. But it costs a lot less, at 0.55% in expense ratio. ELD owns sovereign and corporate bonds issued in more than 10 countries—something that sets it apart in this segment. The fund has a 30-day yield of 5.88%. Russia, Mexico and Brazil are among ELD’s largest country weights. The Russian ruble is up 6% year-to-date. The fund has gained 6.47% so far in 2017.

SPDR Bloomberg Barclays Emerging Markets Local Bond ETF (EBND)

EBND has $124 million in assets and costs 0.40% in expense ratio. The fund tracks a market-value-weighted index of fixed-rate local currency sovereign debt of emerging markets. EBND allocates most heavily to Brazil, South Korea and Mexico, which represent about 35% of the mix, much like competing LEMB. EBND has a 30-day yield of currently 5.14%. The fund is trailing, but not by much, with a 6.13% gain so far this year.

Contact Cinthia Murphy at cmurphy@etf.com

 

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