Emerging-Markets Government Debt: Time To Add To Your Portfolio Or Wait?

by: Sandy Cliff Research

Most emerging-markets government debt ETFs are in negative territory for 2013.

This asset class has obvious long-term potential for greater upside than many other bond categories, but there may be a few clouds on the near horizon. The positives are:

Yield Potential: The average yield on bonds sold in dollars by emerging-market sovereigns fell to 4.5% in January 2013, its lowest level ever. These bonds traded at 5.5% yield just a year ago. The six ETFs highlighted in this article offer yields ranging from 3.49% to 4.55%. This yield is nothing like the yields emerging-market bonds produced over the last decade, but it is still well above Treasuries.

Credit Quality: High percentage of investment grade. The six ETFs highlighted below offer 43% to 75% of their assets in investment-grade holdings.

To put things in perspective, the J.P. Morgan Emerging Bond Index (OTCQB:EMBI), the popular benchmark for emerging-market debt, will turn 20 years old this year. At the time of launch of the EMBI Global in 1993, the average credit rating of emerging bonds in the index was BB. Public debt-to-GDP was almost 100% back then for emerging markets, compared to 69% for developed markets.

In 2013, the fundamentals are reversed: the EMBI Global has an average Baa3 credit rating with 62% of its market cap investment-grade rated. Public debt is now 34% of GDP on average in emerging markets, while developed world debt ratios have ballooned to 119% of GDP.

Economic Growth: Not all, but most emerging-market economies have experienced strong economic growth, improved balance sheets and have built up healthy reserves over the last decade.

Diversification Potential: The local currency ETFs within this asset class offer currency appreciation potential as well as yield.

US Dollar-Denominated ETFs:

PowerShares Emerging Mkts Sovereign Debt (NYSEARCA:PCY): The DB Emerging Market USD Liquid Balance Index tracks returns for emerging-markets U.S. dollar-denominated government bonds issued by approximately 22 emerging-market countries. Countries in the Index are selected annually using a proprietary index methodology and rebalanced and reconstituted quarterly. Equal-weightings of country holdings. Holdings: Government: 99.37%; Credit Grade: High Yield: 51.89%; Investment Grade: 47.50%; Institutional Ownership: 68.15%; Launched 10/2007; 4-star Morningstar rating; Yield: 4.42%; Duration: 9.54 years; YTD: -4.23%; 1-Year: 11.47%; 3-Years: 10.06%; 5-Years: 8.95%; Expense ratio: 0.50%.

iShares Emerging Markets USD Bond (NASDAQ:EMB): Follows the U.S dollar denominated JPMorgan EMBI Global Core Index for emerging-markets debt. This Index is designed to distribute the weights of each country within the Index by limiting the weights of countries with higher debt outstanding and reallocating this excess to countries with lower debt outstanding. The Index may change its composition and weighting monthly upon rebalancing. Includes both fixed and floating-rate instruments issued by sovereign and quasi-sovereign entities from index-eligible countries. Holdings: Government: 80.64%; Corporate: 18.78%; Credit Grade: High Yield: 54.29%; Investment Grade: 43.18%: Institutional Ownership: 56.42%; Launched 12/2007; 3-star Morningstar rating; Yield: 4.35%; Duration: 7.52 years; YTD: -3.50%; 1-Year: 8.99%; 3-Years: 9.18%; 5-Years: 8.59%; Expense ratio: 0.60%.

PCY Total Return Price Chart

PCY Total Return Price data by YCharts

Local-Currency denominated ETFs:

iShares Emerging Markets Local Currency Bond (NYSEARCA:LEMB): Based on the Barclays Emerging Markets Broad Local Currency Bond Index. The Underlying Index is a broad, market value weighted, capped total return index designed to measure the performance of emerging-market sovereign debt that is publicly issued and denominated in the issuer's own domestic market and currency. Holdings in Government Bonds: 99.14%; Credit Grade: High Yield: 12.29%; Investment Grade: 75.55%; Institutional Ownership: 0%; Launched 10/2011; Yield: 3.49%; Duration: 4.32 years; YTD: -0.59%; 1-Year: 6.10%; Expense ratio: 0.60%.

Market Vectors Emerging Markets Local Currency (NYSEARCA:EMLC): Tracks the J.P. Morgan Government Bond Index - Emerging Markets Global Core Index comprised of bonds issued by emerging-market governments and denominated in the local currency of the issuer. Holdings in Government Bonds: 86.42%; Corporate 13.67; Credit Grade: High Yield: 23.94%; Investment Grade: 64.13%; AAA: 4.26%; Institutional Ownership: 45.30%; Launched 7/2010; Yield: 4.13%; Duration: 4.88 years; YTD: -0.81 %; 1-Year: 7.32%; Expense ratio: 0.47%.

Wisdom Tree Emerging Markets Local Debt Fund (NYSEARCA:ELD): Invests at least 80% of its net assets in Local Debt. The fund also may invest in debt securities linked to inflation rates outside the U.S., including securities or instruments linked to rates in emerging-market countries. Holdings in Government Bonds: 84.90%; Corporate: 10.25% Credit Grade: High Yield: 17.20%; Investment Grade: 67.62%; AAA: 9.39%; Institutional Ownership: 39.31%. Launched 8/2010; Yield: 3.89%; Duration: 4.94 years; YTD: -0.77%; 1-Year: 5.58%; Expense ratio: 0.55%.

SPDR Barclays Emerging Markets Local Bond (NYSEARCA:EBND): Uses the Barclays EM Local Currency Government Diversified Index that tracks the fixed-rate local currency sovereign debt of emerging-market countries. Holdings in Government Bonds: 94.7%; Credit Grade: High Yield: 13.89%; Investment Grade: 69.78%: Institutional Ownership: 62.56%; Launched 2/2011; Yield: 4.44%; Duration: 5.00 years; YTD: 0.12%; 1-Year: 7.29%; Expense ratio: 0.50%.

LEMB Total Return Price Chart

LEMB Total Return Price data by YCharts

In Summary:

US Dollar-Denominated: PCY offers an equal-weight approach to 22 countries. This approach usually reduces risk, but distinct sets of very strong, middling, and very weak emerging economies have already begun to emerge. Equal-weight tracking may not work very effectively down the road. EMB sits atop an excellent index, but for those wanting a pure play of government bonds, this one only offers 80% government/19% corporate. For the near and longer term, EMB appears to offer a preferable approach to emerging government debt. This is especially true for those investors wanting a one-stop approach to this asset class.

Local-Currency: LEMB, EMLC, ELD and EBND lack lengthy track records. Being local currency-denominated they do offer the potential for greater upside, albeit with more risk and volatility. The holdings within these 4 ETFs are relatively similar. EBND with 12% of its holdings in Korea and another 12% in Brazil stands out. EMLC makes the strongest play for European emerging countries (34% of its holdings), offering what could be a wise move, considering how much has been poured into Asian and Latin American emerging debt funds over the last five years. As for total number of holdings of each, here is how they look: LEMB (99); EMLC (219); ELD (110); EBND (226). In summary, while these ETFs don't have track records, they offer more diversification than the U.S. dollar-denominated PCY and EMB.

Decisions, Decisions: It's Complicated:

Both PCY and EMB have entered oversold territory at some point this year. Many investors might view this as a sign to buy.

These ETFs have fairly long durations, PCY at 9.54 years and EMB at 7.52 years. Relatively long durations make these two funds more susceptible to losses during periods of rising interest rates.

And as noted in numerous articles published over the last few years and, most recently in the Wall Street Journal, February 8, 2013, "Concern Grows on Possible Bubble in Emerging-Market Dollar Debt," It may be time to take heed.

Investors who are attracted to the quality of the current emerging markets government debt offerings and their still-healthy yields, and who are pessimistic about the U.S. dollar vs emerging economies, should consider the local currency ETFs. Also, the four local currency ETFs noted above have shorter duration holdings ranging from 4.32 to 5.00 years.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.