EM Debt ETF Bandwagon

October 07, 2011

A recent CNBC article highlighted, yet again, that owning debt from the developing world denominated in local currency remains the darling of many investors.

I admit, there’s a compelling case for including emerging market debt in a portfolio. Developing countries have greater growth prospects than developed countries, and many benefit from an abundance of natural resources.

But as people jump on the bandwagon, I wonder if investors fully grasp what they’re getting into.

As a whole, emerging economies don’t carry the heavy debt burdens that have caused Europe and the United States so many major problems. For U.S. investors, the grass definitely looks greener on the emerging side.

And, where they previously had little to no access to this market, they now have a plethora of options to choose from in the form of ETFs.

Eighteen months ago, investors had two dollar-denominated sovereign emerging bond ETFs, the iShares JP Morgan USD Emerging Markets Bond Fund (NYSEArca: EMB) and the PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY).

But now, emerging market local-currency bond funds reign supreme, with coverage expanding past the emerging markets as a whole, and drilling down to regions, countries and sectors.

The problem is that the bigger the menu is, the harder the choices get.

To begin, investors need to understand that the yield premiums paid by emerging market bonds reflect the embedded risks associated with the different countries and their currencies.

Holding bonds denominated in anything other than dollars carries currency risk. Of course, that sword cuts both ways.

Look no further than the difference in the returns of EMB or PCY and the Market Vectors Emerging Markets Local Currency Bond ETF (NYSEArca: EMLC) over the past year. While differences between the ways each fund’s index picks sovereign bonds exist, the biggest difference comes from the currency.

 

PCY vs. EMB: 10/6/2010 - 10/6/2011

Source: Bloomberg

 

 

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