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By Timothy Strauts

Note: This article is part of Morningstar's December 2013 Emerging-Markets Week special report. An earlier version of this article appeared July 11, 2012.

With more than $9 billion in total exchange-traded fund assets, emerging-markets bond ETFs have grown quite popular with investors in the past few years. The emerging-markets bond category has grown into a collection of strategies that offers very different exposures with unique risks.

Sovereign Bonds
Government bonds of emerging-markets countries denominated in U.S. dollars are the oldest type of emerging-markets debt. When emerging-markets countries first started issuing debt in the early 1990s, the only way to get investors interested was to issue the bonds in U.S. dollars. Over the years as investors have become more comfortable with emerging-markets bonds, issuers have lengthened the average maturity of their issues to 10-20 years. The ETFs in this group have average durations between 7 and 9 years, so if interest rates rise substantially, the long duration of these bonds will likely cause high volatility and negative returns.

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Two of the ETFs in this group, iShares JPMorgan USD Emerging Markets Bond (EMB) and PowerShares Emerging Markets Sovereign Debt (PCY), are the oldest and largest emerging-markets bond ETFs. These two ETFs account for 56% of all emerging-markets category assets.

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Government bonds of emerging-markets countries denominated in their own local currency started appearing in the early 2000s. As emerging markets continued to develop, they began issuing bonds in their own currency so they were not exposed to the volatile currency markets. Because investors in these bonds are accepting currency volatility, the average maturity of the issues is only five to 10 years. The lower interest-rate risk helps to counteract the high currency risk. Countries that issue local-currency bonds typically have above-average credit ratings. For example, the largest ETF in this strategy, WisdomTree Emerging Markets Local Debt (ELD), has 90% of its assets invested in investment-grade countries. This is substantially higher than EMB's 70% in investment grade.

Low maturity length and good credit quality make local-currency sovereign bonds an interesting option for an investor looking for above-average yields with below-average interest-rate risk. A word of caution: If the U.S. dollar rises dramatically because of a future financial panic, local-currency bonds will experience negative returns and high volatility. A patient long-term investor could ignore these currency fluctuations as long as the currency movement is related to an external factor like the European debt crisis. Over time, the currencies would likely revert to their long-term trend, so foreign-currency losses would be temporary.

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Emerging-markets corporate bonds are predominately issued in U.S. dollars. The market for local-currency corporate bonds is very small and illiquid, so all of these ETFs invest solely in U.S. dollar issues. The largest ETF in the group, WisdomTree Emerging Markets Corporate Bond ETF (EMCB), has 62% of its assets in investment-grade companies, so credit quality is good. Issuance is dominated by large multinational firms like Petrobras (PBR) and Vale (VALE). Bonds are typically issued in the five- to 10-year range. If you exclude the high-yield ETFs, this group has similar yields to the U.S.-dollar sovereign ETFs discussed earlier. Corporate bonds could be a good option for investors desiring a good yield, lower interest-rate risk, and U.S. dollar exposure.

The high-yield ETFs are for investors willing to accept much higher volatility for the hope of enhanced returns. Market Vectors Emerging Markets High Yield Bond ETF (HYEM) focuses exclusively on corporate bonds, and the iShares Emerging Markets High Yield Bond (EMHY) holds a combination of sovereigns and corporates. (Disclosure: EMHY tracks an index created by Morningstar.)

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Dim sum bonds are Chinese yuan-denominated bonds that trade in Hong Kong. These debt instruments are issued by Chinese and non-Chinese corporations and governments and can be purchased by non-Chinese investors. Dim sum bonds were introduced recently as part of the Chinese government's efforts to internationalize its currency, and at this time, the market is very small, with outstanding bonds totaling about $50 billion. Demand for dim sum bonds is very strong, mainly as a currency play. As a result, dim sum credit spreads are tighter relative to comparable markets, and yields are lower than comparable onshore yields.

Dim sum bonds are denominated in offshore Chinese yuan, known as CNH, and not onshore Chinese yuan, known as CNY. While the CNH and CNY generally trade in line with each other, given the nonconvertibility of the CNY, the two currencies effectively trade in different markets and therefore are subject to different supply and demand trends. This is a very specialized market and is probably not appropriate for the average investor at this point.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Emerging-Markets Bond Breakdown