Emerging Market Debt Offers Diversification

When it comes to portfolio construction, diversification is a cornerstone principle, and one that ETFs make easy for investors. On the equity side, investors are familiar with holding an allocation to many different asset classes, including emerging market ETFs.

Approximately 5.9% of assets held within equity ETFs are in emerging market ETFs, the largest being the Vanguard FTSE Emerging Markets ETF (VWO).

But emerging markets are not as popular when it comes to fixed income. In fact, of the $7.1 trillion in ETF assets, just under $34 billion is held in emerging market debt ETFs. As a share of fixed income assets, which stands at around $1.27 trillion, this represents about 2.6%.

Aside from assets, the vast majority of fixed income ETFs offer exposure to the U.S. bond market only. But just as there are benefits to diversifying equity exposure by region, the fixed income portion of a portfolio can benefit from an allocation to non-U.S. securities.

Potential for Higher Yields

One benefit of having an allocation to emerging market debt is the higher yield offered by this asset class. The iShares JP Morgan USD Emerging Markets Bond ETF (EMB) is the largest emerging market debt ETF by assets, standing at $19.2 billion. This ETF currently has an average yield to maturity of 4.85%.

This is more than double the average yield to maturity of the iShares Core U.S. Aggregate Bond ETF (AGG), currently 1.94%. It is also higher than the yield offered by the iShares iBoxx USD High Yield Corporate Bond ETF (HYG), currently 4.42%.

For those willing to dip down in credit quality, the iShares J.P. Morgan EM High Yield Bond ETF (EMHY) has an average yield of maturity of 6.81%. And the VanEck Emerging Markets High Yield Bond ETF (HYEM), which tracks a different index than EMHY, has a yield to maturity of 8.82%.

As with any fixed income investment, higher yields are correlated to a higher level of risk. But for income-sensitive investors able to take on this elevated level of risk, these higher yields could be an attractive benefit.

Diversification Benefits

Adding an allocation to emerging market debt, particularly local currency bonds, can add diversification benefits to a portfolio. One reason for this is that the return for local currency debt is driven by two separate components—local interest rates and currency movements.

While central banks around the world, including emerging markets, are expected to hike rates, it is possible that emerging markets banks are ahead of the curve. Fran Rodilosso, head of fixed income ETF portfolio management at VanEck, elaborates on this point.

“Emerging market central banks are held to a much higher standard,” he explained. “For the most part, they can’t pursue the type of QE and zero interest rate policies that developed market central banks can because their currencies wouldn’t react the same. These valuations in emerging market debt, as a generalization, are in a better position than developed markets.”

“Emerging markets central banks were hiking last year," Rodilosso added. “They may or may not be forced to continue hiking in the face of U.S. Fed rate hikes. A lot has already been priced in, and that’s where we think the relative value is.”

Risks Of Unhedged Exposure

However, investors should keep in mind that holding local currency bonds exposes them to a higher level of risk. Currencies tend to be more volatile than bonds, and should the dollar strengthen relative to emerging market currencies, this could cause local currency ETFs to perform worse than their USD-denominated counterparts.

This was the case last year, causing the return for the VanEck J.P. Morgan EM Local Currency Bond ETF (EMLC) to be significantly lower than that of either dollar-denominated EMB or even the lower quality HYEM.
 

Rodilosso commented on 2021’s performance, saying, “Overall, the majority of that negative return was due to FX losses. EM currencies have looked cheap for several years, yet they’ve continued to underperform.”

Given that the strength of these currencies relative to the dollar is at historically weak levels, these currencies should eventually appreciate. When this occurs, it would boost local currency bond ETF returns relative to dollar-denominated ETFs.

”There are a variety of scenarios this year where you could see EM currencies do well,” Rodilosso noted. “The same case could have been made at the beginning of 2020 and 2021, so timing is challenging. But the fact that central banks were out in front last year, at some point they should be rewarded for that.”

Contact Jessica Ferringer at [email protected] and follow her on Twitter