What's Ailing Emerging Market Bond ETFs?

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Includes: EMB, PCY
by: Tom Lydon

A strong dollar, coupled with a spate of surprising interest rate hikes in some developing markets, are among the factors punishing emerging markets debt this year, pressuring exchange traded funds such as the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA:EMB) and the Invesco Emerging Markets Sovereign Debt Portfolio ETF (NYSE:PCY) in the process.

EMB tracks the J.P. Morgan EMBI Global Core Index, a market-cap-weighted index. Potential investors should note that since it is a cap-weighted index, countries with greater debt will have a larger position in the portfolio.

The Federal Reserve began its current tightening cycle in 2015, and while the first few rate hikes did not pinch emerging markets debt all that much, that scenario is changing in a big way this year.

"But here's the real problem going forward that virtually no one in the mainstream's talking about," according to Palisade Research. "These Emerging Market governments and corporations have massive amounts of dollar-denominated debts maturing over the next three years - nearly $3.25 trillion (90% being corporate bonds)."

With respect to value compared to price, many of these ETFs from abroad present a profitable opportunity that can be realized, especially if China and the U.S. eventually ameliorate their trade differences by year's end. It presents an interesting opportunity for the investor who is seeking value in terms of locating discounted assets such as those in emerging markets debt, but other potential problems linger.

China Investor Issues

Chinese debt, corporate and sovereign, is another potential concern investors need to consider.

"And more than half from China alone. Giving some context here: the Chinese government and corporations owe roughly $1.75 trillion - nearly 55% of the total - of bonds maturing through 2020. And they won't be able to roll it over (refinance) cheaper as rates worldwide rise - led by the Fed's tightening," according to Palisade.

As investors look for opportunities after the pullback, with some turning the emerging market countries like China, some may consider Chinese financial companies and related country-specific exchange-traded funds for a more stable approach to the developing economy.

According to State Street Global Advisors, cheap valuations and a government that can easily bail out pockets of China's financial sector from instability makes the country's bank stocks a buy, Bloomberg reports.

"Overindebted Emerging Market governments and corporations will have to get their hands on huge amounts of dollars over the next few years," according to Palisade. "But with interest rates rising. And the dollar getting stronger - the expensive cost to roll over all this debt poses a new risk for Emerging Markets. Especially the countries and firms with poor credit ratings."