Emerging Market Bond ETFs A Quandary

July 24, 2018

Fran RodilossoLike their equity counterparts, emerging market bond ETFs have been getting hit in 2018. In most cases, dollar-denominated emerging market bond ETFs are down more than 4%, while local-currency ETFs are down more than 7%.

Is now a good time to buy EM bond ETFs? If so, what type of emerging market bond ETF should investors buy? To help answer those questions and more, ETF.com spoke with Francis Rodilosso, head of fixed-income ETF portfolio management at VanEck, and an expert on emerging markets.

ETF.com: After two strong years of returns for emerging market bonds, they’re doing poorly this year. Why is that the case?

Francis Rodilosso: We saw a couple of phenomena take place that caused a reversal, one of which was a rebound in the U.S. dollar. That was in part due to continued rising rates and fairly good economic prospects for the U.S., compounded by fear of trade wars and other geopolitical risks.

The escalation of the trade rhetoric caused a lot of concern about China growth and all of the Asian countries that are dependent on China growth.

At the same time, there were several countries within the EM space with escalating risks, including Turkey, with its big current account deficit and unorthodox central bank policy; and Argentina, also with a large current account deficit and high inflation rate.

That said, there’s still the underlying theme of favorable fundamentals versus developed markets. Economic indicators are still showing fairly robust growth for emerging markets for 2018 and beyond. We think a lot of the repricing in many EM assets has occurred without there being a major shift to the negative in fundamentals.

ETF.com: Is this a buying opportunity in EM bonds, or should investors wait for more shoes to drop before wading in?

Rodilosso: Investors should be looking. There’s still potential for further escalation of the trade disputes. We have a Brazilian election in the fall.

Additionally, July and August are fairly illiquid months. Good news could have an outsized effect, but so could bad news, with markets being slightly less liquid at this time.

It is very, very difficult to time, and that’s probably why I’m a passive manager and not an active one.

But since prices have come down without fundamentals being severely undermined, I definitely think this is a time where you should be looking. Have we seen the lowest levels of the year? I couldn’t make that prognostication.

ETF.com: There are a lot of flavors of emerging market bond ETFs that investors can buy today, from dollar-denominated ETFs to local-currency ETFs to corporate ETFs. Which do you favor?

Rodilosso: For investors who see pure local emerging market bonds as just too volatile, a blended approach that combines emerging market sovereign and corporate bonds across hard and local currencies may be an attractive alternative. That’s the approach that the VanEck Vectors Emerging Markets Aggregate Bond ETF (EMAG) takes.

It’s a passive strategy that hasn’t really gotten any traction yet, but it deserves more attention than it’s received.

 

YTD Returns For Various EM Bond ETFs

 

We think the argument for that approach is that it has less volatility than a pure local approach. It’s also the most diversified access to emerging market bonds that you could get, because it includes sovereign and corporate debt in local and hard currencies.

ETF.com: You mentioned the blended approach is great for people who don’t want the volatility. For people who don’t mind volatility, are local-currency bonds the way to go given how beaten down emerging market currencies are?

Rodilosso: It’s an asset class where a lot of value has come back in. When you look at how beaten up the currencies have gotten, not just on a nominal basis—but on a real effective exchange rate basis versus historical levels—many are at the weakest points they have been at in a very long time.

From a medium and a long-term perspective, there are merits to local currency bonds. There is carry. There is low correlation to the U.S. Aggregate Bond Index or the 10-year Treasury yield.

There is potential value across the board. If you think of it as a trade, the timing is difficult. If you think of it as a long-term part of your overall fixed-income portfolio, then it’s a good time to start looking.

ETF.com: Can EM bonds do well even if EM equities are struggling?

Rodilosso: Yes, it’s possible because the construction of the indices is so different in terms of what countries and regions are represented.

EM equities are still very Asia-heavy in terms of the indices and the opportunity set. EM debt is more broadly distributed between Asia, Eastern Europe, Middle East, Africa and Latin America.

China today is not even in the emerging market local debt index. Additionally, Taiwan, Korea and Singapore are not even considered emerging markets within most of the EM debt space. Many of those countries dominate EM equity indices.

If your drivers of return on the debt side are some of the Latin or the Eastern European countries that have cheapened up, it’s possible they could perform fairly well relative to equities at a given point in time, and vice versa.

Email Sumit Roy at [email protected] or follow him on Twitter sumitroy2

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