By Timothy Strauts
In the past decade investors have embraced international-stock investing, but many of those same people still own all their fixed income in U.S. bonds. When interest rates were higher you did not need to take on the additional risk of international investing. But today, with ultra-low interest rates and concerns about the credit quality of the U.S. government and corporations, it may make sense to look to emerging markets for new opportunities.
Emerging-markets debt historically has been very volatile and prone to defaults. Russia defaulted on its debt back in 1998, and both Brazil and Argentina delivered major headaches to investors shortly after the turn of the century. Today, however, the tables have turned. Most pundits are now more worried about developed-world economies, especially in Europe, than those of emerging economies. Many emerging markets have improved their financial stability by abandoning fixed exchange rates, adopting inflation targeting, reducing external debt, and lowering fiscal deficits. By following these sound fiscal and monetary policies, the average debt/gross domestic product ratio of emerging-market countries is less than 50% while the United States' ratio is closer to 100%. As a result there is growing belief that, despite emerging markets' lower credit ratings, they may actually be better credit risks than many developed markets are.
If you can endure the risks and are considering investing in emerging-markets bonds, the first thing you need to decide is whether to buy U.S.-dollar-denominated or local-currency bonds. Most debt was issued in U.S. dollars until recently because investors refused to take the risk of currency exposure to these emerging countries. This created a problem for emerging countries if their currency devalued versus the dollar, which made debt payments much more expensive. As a result, in the past few years emerging countries have worked to reduce their reliance on external funding and the risks of issuing U.S.-dollar debt. They have developed local bond markets that recently have begun to offer longer-maturity securities as demand has increased.
The liquidity in the local markets is adequate but not yet as liquid as the U.S.-dollar emerging bond market. The lower liquidity levels and fluctuating exchange rates make local-currency bonds more volatile than their U.S.-dollar-denominated counterparts. On the other hand, local-currency bonds act as a hedge on further U.S.-dollar weakness. If emerging markets continue growing their economies faster than does the United States, their currency could rise versus the dollar, which will be another source of positive returns for local-currency bonds. The flip side, of course, is that these currency fluctuations could lead to substantially higher volatility.
An investor looking for higher yields than comparable U.S. offerings and moderate risk should look to the U.S.-dollar emerging-market bond exchange-traded funds. For enhanced diversification, higher risk, and greater potential long-term returns, local-currency emerging-markets bonds are the answer.
Let's review the current ETF investment options in the emerging-markets bond space.
Powershares Emerging Markets Sovereign Debt (PCY)
PCY is a U.S.-dollar-denominated fund that employs an equal-weight strategy, so all countries have about the same weight in the index. The fund currently invests in 22 countries and owns about three bonds from each country. This very broad diversification minimizes the risk of any one country defaulting on its debt. PCY's portfolio has an average maturity of 14.7 years, which is the longest-term portfolio in the category. The fund's increased interest-rate risk hasn't hurt returns yet because rates have been declining globally for the past few years. IShares Barclays 10-20 Year Treasury Bond (TLH) holds a portfolio of U.S. Treasury bonds and has a similar average maturity to PCY but only has a yield to maturity of 2.48%. PCY yields 5.79% which gives PCY a 3.31% advantage in terms of yield. In this low-interest-rate environment there are definitely increased risks with emerging markets but you're getting paid quite well to take those risks.
iShares JPMorgan USD Emerging Markets Bond (EMB)
EMB is the largest and most liquid fund in the category, but it is also the most expensive at 0.60%. The fund only owns U.S.-dollar bonds and is market-value-weighted, so the countries with the most debt have the highest weighting in the index. The index does limit the weights of the largest debtor nations; 8% is the greatest allocation to any one country. The top five countries in the index are Russia, Brazil, Mexico, Turkey, and the Philippines. This constitutes 38% of the total assets. The index currently has holdings from 36 different countries. The portfolio has an average duration (a measure of interest-rate sensitivity) of around 7.1 years and offers a yield to maturity of 5.31%.
WisdomTree Emerging Markets Local Debt (ELD)
ELD is the only option that follows an active strategy in local-currency bonds, but don't expect a lot of frequent portfolio-allocation changes. The strategy committee implements a tiered strategy that attempts to put more assets in countries that maintain strong fiscal discipline. They avoid countries with high debt/GDP ratios, inadequate foreign reserves, slow economic growth, and rising inflation. Currently, the fund has its greatest weightings in Brazil, Mexico, Malaysia, and Indonesia. So far the committee has implemented only two changes: adding a small exposure to China and increasing the fund's allocation to Russia. The portfolio has 68% of fund assets allocated to countries with investment-grade-credit ratings. ELD has a current yield to maturity of 5.4% and a duration of only 4.5 years. With ELD you're getting an investment-grade portfolio with an attractive yield, relatively low interest-rate risk, and the potential for increased returns if the U.S. dollar weakens versus emerging markets.
Market Vectors Emerging Market Local Currency Bond (EMLC)
EMLC is a local-currency fund and, with an expense ratio of 0.49%, is the cheapest offering in the category. The fund tracks a market-cap-weighted JPMorgan index. To reduce the effect of heavily indebted countries becoming too large a percentage of the fund, all country allocations are capped at a 10%. The countries with allocations near 10% are Poland, South Africa, Brazil, and Mexico. Because highly indebted countries usually have lower credit ratings, only 45% of EMLC is invested in countries with investment-grade credit ratings. While the portfolio might be of slightly lower quality then ELD's, it does offer a higher yield to maturity of 6.35%.
iShares Emerging Markets Local Currency Bond (LEMB)
LEMB was just launched recently and as is the local-currency counterpart to EMB in the iShares family of ETFs. It has a yield of 6.04% and an average maturity of 5.8 years; both figures are similar to the other local-currency options. The main differentiating factor between LEMB and the other local-currency ETF options is that there is no cap on the country weights. The top weightings are South Korea (21%), Brazil (14%), Mexico (7%), and Poland (6%). With 48% of the fund invested in only four countries there is a lot risk of concentration risk in this fund. The top-heavy weighting is centered on countries with more-established bond markets that offer more liquidity, so it is likely that this ETF will trade at slightly tighter bid-ask spreads than competing ETFs.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.