Buy Emerging Market Bond ETF Dip?

Emerging market bond ETFs hit a rough patch in recent weeks, dropping quickly amid sudden dollar movements and geopolitical concerns.

The sharp move lower came on the heels of two-plus years of strong performance in dollar-denominated emerging market bonds, local-currency sovereign bonds as well as in high-yield debt—as measured here by the iShares JP Morgan USD Emerging Markets Bond ETF (EMB), the VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (EMLC) and the iShares Emerging Markets High Yield Bond ETF (EMHY), the biggest ETF in each of those bond segments.

Political risks and the bearish trend for the U.S. dollar have caused some repositioning among portfolio managers in emerging markets this year, according to Fran Rodilosso, head of fixed-income ETF portfolio management at VanEck.

Charts courtesy of StockCharts.com

Local Currency Debt

The weakness has been particularly evident in local-currency ETFs such as EMLC, where currency moves impact returns directly.

“The big turn in local debt is that local currencies were helping performance in 2016-2017, and earlier this year; most of the return was tied to carry and to currency returns,” Rodilosso said. “But now it’s the main contributor to negative returns this year.” Specifically, he added, some countries have helped lead these losses.

Take Turkey for example. The country is headed to a presidential election with a nonmarket-friendly candidate in the lead. The Turkish lira is down about 17% year-to-date. Argentina is another tough spot, facing negative real rates, according to Rodilosso, and with a central bank that has been able to mitigate some of the bleeding in the currency, but it’s still down about 20% this year.

“These are extreme underperformers,” Rodilosso said. “Basically, all negative return in EM local is explained by currency movements.”

Dollar Denominated Debt

In the case of dollar-denominated emerging market debt—funds such as EMB—the decline is being led by higher U.S. Treasury rates.

These bonds are typically highly correlated to U.S. Treasurys, and EMB has duration of some 6.6 years, making it sensitive to what happens to U.S. longer-term debt rates.

High-Yield Bonds

On the high-yield front, EMHY, which combines sovereign and corporate junk bonds, has fared slightly better, because corporates are down less than sovereigns due to their lower duration exposure, and a little more carry on the high-yield side, Rodilosso notes.

In other words, whether you own local-currency EM bond ETFs, dollar-denominated EM bond funds or high-yield ETFs, each segment has struggled for distinct reasons in recent weeks.

Pain Before Gain?

In the short term, there could be more pain ahead in the form of volatility. But the fundamental story supporting emerging markets in general remains intact, and that means the recent dip could bring buying opportunities in its wake.

Mark Dow, founder of Dow Global Advisors and an expert on emerging markets, suggests investors consider just that: buying the dip.

“I think we are at a local low in the period of underperformance emerging markets have been experiencing relative to developed markets,” he said. “I expect the general underperformance of EM to last longer, but this right now is a local low in that longer process and therefore attractive.”

Rodilosso, whose firm is the issuer behind EMLC, agrees.

“The same fundamental arguments remain in place for EM as a whole,” he said. “They are higher-growth countries, they offer higher real interest rates on their local debt, they have lower overall debt relative to developed markets, and overall lower deficits versus developed markets.

Know Your Exposure

Again, remember that each of these EM bond ETFs brings different risk/rewards characteristics. EMB and others like it bring correlation to Treasurys, so their path is more sensitive to duration. EMLC and other local-currency bond ETFs have a path that’s more sensitive to single-country stories and portfolios often more concentrated in country exposure. EMHY and other high-yield funds bring credit risk and sector concentrations.

“There are a lot of risks out there in this asset class, but this doesn’t feel like a big sell-off where everyone has capitulated,” Rodilosso said.

EMB has $11.8 billion in total assets and costs 0.40% in expense ratio; EMLC has $5.2 billion in assets and costs 0.42%; and EMHY has $546 million in assets and costs 0.50%.

Contact Cinthia Murphy at [email protected]