Investors are finding their way into emerging market bonds through dollar-denominated and local-currency ETFs.
Investors have been slowly returning to emerging market debt funds, looking for value opportunities in a segment that was largely shunned in 2013 amid depreciating local currencies and various rate hikes in many of those markets.
But when it comes to owning foreign bonds, it makes a difference whether the debt is dollar denominated or not. That difference might explain why asset flows into ETFs in the segment—as well as performance—is dispersed this year.
“In the U.S., yields have begun to rise and spreads over Treasurys are compressed below average historical levels, making it harder to find attractive income opportunities that also avoid unwanted interest-rate risk,” Kathleen Gaffney, vice president and fixed-income expert at Eaton Vance, said in a commentary published on Wealth Management this week. “Emerging-market debt, on the other hand, has gotten cheaper due to the sell-off over the past year.”
“This comes as investors have begun to price in not only the end of the Fed’s quantitative easing, but an eventual rise in the Fed’s base rate, effectively raising the bar on the so-called carry trade on emerging-market currency short-term yields,” she said.
While advocating that investors need to be choosy and nimble in the space to capture the right opportunities and minimize exposure to a “tremendous amount of sovereign and political risk,” Gaffney’s views seem to echo what many market analyst and fixed-income experts are saying, which is that valuation opportunities abound in the emerging market debt space, even if the segment promises head winds and a volatile ride.
Either way, when it comes to owning emerging market debt through ETFs, choosing between sovereign and corporate, as well as dollar-denominated and local currency bonds can lead to very different investment outcomes.
Consider the WisdomTree Emerging Markets Local Debt ETF (ELD | B)—the largest local-currency emerging market bond ETF in the market today, with nearly $1 billion in assets—and the iShares J.P. Morgan USD Emerging Markets Bond (EMB | B-24), the largest passively managed dollar-denominated emerging debt portfolio, with more than $4.3 billion in total assets.
In theory, emerging debt in local currency should do well when the U.S. dollar weakens against developing market currencies, ETF.com analyst Ugo Egbunike points out. That’s because the weaker dollar translates into added returns for U.S. investors. Year-to-date, the dollar—as measured by the U.S. dollar index—has slid about 0.2 percent.
But the modest decline hasn’t much helped a fund like ELD so far this year, thanks in part to falling U.S. Treasury yields. The 10-Year Treasury yield has now slid 11 percent year-to-date, hovering at 2.70 percent.
ELD has not only struggled to rally, but has been bleeding assets. Investors have already yanked a net of $270 million from the fund so far this year, extending its 2013 net outflows of $51 million as it slid more than 10 percent in a 12-month period.
By comparison, EMB has attracted more than $784 million in net new assets since the beginning of the year, after bleeding a whopping $2.75 billion in 2013 as it slid 7.7 percent in 12 months. EMB is also outperforming ELD by almost 4 percentage-points year-to-date.
Chart courtesy of StockCharts.com
These two funds differ beyond the currency element.