A Closer Look At Emerging Markets Bond ETFs

November 03, 2008

Two new funds take different paths in avoiding riskier debt and investing in sovereign issues. Are correlations set to widen with U.S. markets?



At the end of last year, two new exchange-traded funds became available in the U.S., providing investors the opportunity to include emerging markets bond funds into their portfolios for the first time.

Now as they approach their first full year of operations, what exactly have the PowerShares Emerging Markets Sovereign Debt Portfolio (NYSE: PCY) and the iShares JPMorgan USD Emerging Markets Bond Fund (NYSE: EMB) brought to ETF investing?

For one, these two funds provide inexpensive access to markets previously difficult or costly to invest in. But clearly the other major appeal of PCY and EMB is that both offer low correlations to U.S. markets over longer periods and the potential of equitylike returns.

Below is the yearly correlations of both ETFs' underlying benchmarks using monthly price data. The graph shows low correlations between the S&P 500 and these indexes over a longer period, which indicates that emerging markets debt ETFs can provide significant risk reduction to U.S. investors.


Chart: PCY and EMB Correlation with S&P 500 (1992 - 2008)


As the graph indicates, the indexes which PCY and EMB track have a low long-term correlation to the S&P 500, (0.57 and 0.59, respectively), over the time period graphed. So far in 2008, by historical standards, we've seen a highly correlated year between emerging market bonds and the S&P 500's returns.

At first glance, the performance this year of both ETFs might seem disappointingly poor. But consider the global credit problems and the pullout from emerging capital markets and the picture comes into better focus.

Year-to-date heading through October, PCY was down 35.02% and EMB had fallen 24.11%, according to Bloomberg data.

During times when defaults seem to be looming, major sell-offs can be expected, especially from commodity-based countries like Russia, Brazil and Venezuela. This year has been a unique period when all credit markets have seen investors running from high-yielding and high-risk debt portfolios. This combined with massive sell-offs from emerging markets in general have created a situation very unfavorable for emerging markets bond investors.

In fact, The Economist reported that as of October 29, the International Monetary Fund (IMF) has approved a new "short-term liquidity facility." This new facility will provide three-month loans to emerging economies and promises loans in a timely manner.

According to the magazine, the IMF will have less stringent conditions for the loans and a guarantee of quick responses to the loan request. The loan has many other functions that should provide emerging countries with the liquidity they may need in an extremely timely manner. This new plan should ease default fears among investors in sovereign debt issues and should have a direct impact on easing the default and credit risk of emerging market debt portfolios during this current economic climate.

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