Why Now May Be The Right Time For Emerging Market Bonds

 |  Includes: ELD, EMB, IBND, PCY, PICB
by: Matt Tucker, CFA

After several months of not hearing much about emerging market (EM) bonds (other than "Where's the exit?"), we have recently been fielding questions on whether there is value in this space. A key focus is the relative value of USD denominated EM debt relative to other fixed income sectors, which I discussed in a Blog post last quarter.

Let's review the basics. A lot of investors evaluate fixed income sectors by looking at the level of yield they might receive for a given level of risk. We continue to explore how investors consider interest rate risk and portfolio positioning in the current environment. In addition to interest rate risk, there is substantial emphasis on the yields available for different levels of credit risk, which is essentially the risk that an issuer will not make regular coupon payments or will not be able to pay back principal. Credit ratings provided by third party agencies like S&P and Moody's are often used as a way of gauging the credit risk of an issuer. It essentially measures a debtor's ability to service and pay back its obligations.

At a high level, bonds are divided into two major categories: investment grade and high yield. Investment grade is defined as ratings at or above BBB- for S&P or Baa3 from Moody's, and high yield is defined as ratings below those levels. Many of the fixed income ETFs in the market provide exposure to either investment grade or high yield debt. For example, the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD), our flagship Investment Grade Corporate exposure ETF, provides exposure to higher quality corporate bonds while the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG), our flagship high yield ETF, provides exposure to lower rated corporate issuers.

As we know from the risk-return tradeoff, the higher the level of credit risk an issue has the higher the yield will likely be. Credit risk is often measured with a metric called Option Adjusted Spread or OAS, which considers the additional yield an investor is paid over and above the yield on a similar Treasury security. If we compare the credit spreads of different corporate ETFs to their fund ratings we find a typical upward sloping curve that reflects the fact that investors will require more yield to compensate for higher levels of credit risk.

Here is an illustration of this relationship using ETFs with a range of levels of credit risk:

Click to enlarge

Source: BlackRock as of 5/9/2014
For more information on S&P fund credit ratings, please click here.

At the far left of the graph is the iShares Aaa-A Rated Corporate Bond ETF (NYSEARCA:QLTA). This fund primarily provides exposures to securities with ratings of A or higher. At the far right of the graph is the iShares B-Ca Rated Corporate Bond ETF (BATS:QLTC). This fund provides exposure to the lower credit quality segments of the high yield market, and because of the level of credit risk in the fund, it offers the highest yields of the group.

So where does EM debt fit into the risk versus return landscape? Typically EM lies somewhere in the middle, as the EM bond universe contains a combination of investment grade (Chile, Malaysia, Mexico and others) and high yield (Ukraine, Argentina, Venezuela) issuers. This changed in May/June 2013 as investors became concerned about credit risk and yield spreads widened in response. Since that time we have seen a steady tightening of investment grade and high yield credit spreads across the board as investors have moved back into those sectors. EM spreads have tightened some as well, but not nearly as much. As a result, the yields on EM debt appear to be unusually wide given the credit quality of the issuers. EM credit spreads are trading near those for the high yield market, even though almost 70% of the EM issuers in a broad EM vehicle, like the iShares Emerging Markets USD Bond ETF (NYSEARCA:EMB), are investment grade.

Click to enlarge

Source: BlackRock as of 5/9/2014

The above chart highlights the divergence in spreads that has occurred since 2012. The question for investors today is, will EM rally versus corporate bonds? It's hard to say. Keep in mind that part of what is keeping EM wide is that the universe, and in particular EMB, include exposure to the debt of countries that have dominated headlines lately. This includes Russia, which makes up 5.61% of EMB, Ukraine which makes up 2.85%, and Brazil which makes up 6% (Source: BlackRock as of 5/1/2014).

It is certainly possible that EM debt can remain at elevated spread levels if we continue to see political and economic challenges in the issuing countries. At the same time we are seeing some investors move back into the sector as evidenced by the $584 million of flows into EMB this year through May 1st (Source: Bloomberg). Bottom line, for investors looking to add yield to a portfolio, EM debt may be an alternative they should take a closer look at. Just remember that, as always, yield isn't free.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

Holdings are subject to change.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets, in concentrations of single countries or smaller capital markets.