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

 

 

 

Over the first half of 2011, many emerging economies like Brazil raised interest rates, making the yields on their bonds attractive for U.S. investors facing near-zero yields at home.

The flow of capital to these economies resulted in the continued weakening of the dollar, a boon for investors who were long local currencies, such as the Brazilian real.

That said, the same risk that delivered outperformance has wreaked havoc on investor returns since the markets peaked in late April and began growing quite volatile in mid-July.

Investors fled to the safety of the dollar-denominated assets such as Treasurys, strengthening the greenback, and pushing prices of emerging market bonds down as their yields spiked.

Apart from the generic flight out of developing-country assets when financial markets become roiled, it’s also important for investors to understand that a lot of different types of economies fall under the emerging market umbrella.

Differentiating between the commodity producers such as Chile and commodity users such as China goes a long way toward understanding how other macroeconomic changes will impact a given country, and why one emerging market debt fund may perform differently than another.

China’s a great case in point. It’s a burgeoning power, gobbling up resources and expanding at rates previously unheard of in the history of capitalism.

However, what happens in China depends solely on the whim of the government, which still keeps a tight noose on just about everything in that society, from access to Internet sites to access to capital for entrepreneurs.

If you bought into the recently launched Guggenheim Yuan Bond Fund (NYSEArca: RMB) and the PowerShares Chinese Yuan Dim Sum Bond Fund (NYSEArca: DSUM), you ultimately put your faith in the Chinese government doing right by you. At the very least, investors need to grasp the finer implications of where they’re putting their money.

In the end, the only free cheese is in the mousetrap.

Whenever something previously unavailable to investors becomes just a limit-order away in an exchange-traded fund, it’s important to remember to do your homework, because the risks and benefits of holding emerging market local currency bonds go hand in hand.

 

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