Rethinking Risk With Corporate Emerging Market Bond ETFs

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 |  Includes: CEMB, EMB, LQD
by: Matt Tucker, CFA

Last month, iShares introduced CEMB, which gives investors exposure to emerging market corporate debt. Since the fund’s launch we’ve fielded some questions from clients wondering why the yield on CEMB is close to the yield on another one of our funds - EMB, which provides access to sovereign emerging market debt.

As of May 11, CEMB had an average yield to maturity of 4.95%, while EMB’s yield was 4.99%. If I’m taking on more risk with CEMB by investing in corporate vs. sovereign debt, clients have asked, why aren’t I receiving a higher yield in return? The answer is because in this case, the risk associated with corporate emerging market bonds might not be as elevated as many investors would think.

First, let’s look at the amount of duration, or interest rate risk, of these two funds. As measured by its duration of 5.5 years, CEMB has less interest rate risk than EMB, which has a duration of 7.42 years as of May 14.

Now, let’s look at the holdings of EMB and CEMB. EMB holds securities backed by emerging market sovereign governments, like Peru, Russia and the Philippines.

CEMB meanwhile gives investors access to the corporate debt of companies domiciled in emerging market countries. It holds the debt of big companies like Brazilian oil company PetroBras (NYSE:PBR) and South African electricity producer, Eskom Holdings. Although the issuers in CEMB are based in emerging markets, many have investment grade credit ratings, including a fair number with AA or A ratings. As the chart below illustrates, the composition of CEMB is slightly higher on the credit rating spectrum than EMB:

Credit Rating Breakdown:

Click to enlarge

Investors might assume that emerging market corporate bond ETFs would consist of bonds that have lower credit ratings than those in emerging market sovereign ETFs, making them riskier holdings that provide a higher yield. But this chart illustrates that is not always the case, and it helps to explains why a fund like CEMB would have a yield similar to that of EMB.

How could investors consider using CEMB in a portfolio?

1.) Diversify away from U.S. corporate debt: For investors who own a fund like LQD, which holds investment grade U.S. corporate debt, CEMB offers an opportunity to diversify away from U.S. corporate debt while potentially picking up additional yield. LQD’s average yield to maturity was 3.52% as of May 11. Additionally, with low correlations to other fixed income sectors and equities, emerging market corporate bonds can add diversification to investment portfolios. (Past performance is no guarantee of future results.)

2.) Access the emerging market consumer: As Russ Koesterich has noted, emerging market growth continues to create hundreds of millions of new middle-class consumers. By 2025 China, India and Brazil are respectively expected to be the 2nd, 4th and 9th largest consumer markets in the world, according to McKinsey. The emerging market corporations whose bonds are held in CEMB are selling their wares to this growing consumer base.

3.) Gain access to emerging market growth with less volatility than emerging market equities. For the past 10 years, emerging market corporate bonds have had total return volatility of 12.5% as compared to 24.4% for emerging market equities, using data from Morningstar and MSCI, as of April 30.

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