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Seeking Yield with Emerging Market Bond ETFs

A guide to investing in emerging market debt; a market offering yields that are much higher compared to “safe” alternatives

Jose Garcia-Zarate 18 July, 2012 | 4:49PM

Emerging market exposure is now part of most investment portfolios, with investors lured by comparatively high returns and an increasing perception of diminishing risk. Initially the bulk of emerging market exposure was sought in equity markets, but increasingly, investors have been seeking the benefits of emerging market bonds, which are underpinned by a compelling macroeconomic rationale. Emerging market economies have become key engines of global growth and are weathering the crisis in much better shape than their developed counterparts. More crucially, in a world where investors are worried about excessive leverage, emerging market economies stand out as an example of fiscal soundness. As a result, emerging market debt credit quality has steadily increased; and while their bond yields have fallen, they still remain enticingly above those offered by “safe” alternatives in developed nations. In addition, historically emerging market debt has shown a low correlation with traditional fixed income investments, which helps investors diversify risk in their portfolios.

Exchange traded fund (ETF) providers have been keen to capitalise on this growing investment trend by increasing their offerings, both in terms of number of funds and exposures to the varied segments of the emerging debt market. As I write this, total assets under management in 10 European-domiciled emerging market debt ETFs surpass EUR 2.5 billion. These ETFs cover government and corporate emerging bond markets, which are denominated in USD and local currencies.

Below is an overview of each of the different ETF types.   

USD-Denominated Emerging Market Government Bond ETFs
Before becoming the macro success story of today, emerging market government bond issuance had to be almost exclusively undertaken in US dollars in order to make it palatable to wary international investors. As years went by, investors became more comfortable with the notion of holding emerging market debt, in turn allowing for a steady increase in the maturity of these USD-denominated instruments. As we write, the ETFs covering this particular debt market show fairly high duration metrics (e.g. 7-8 years), making them proportionally more vulnerable to capital losses at times of rising interest rates. In this regard, as these bonds are USD-denominated, investors would need to primarily monitor the US monetary policy outlook.        

There are two specific UK and European-domiciled ETFs that offer exposure to this segment of the debt market. The iShares JP Morgan USD EM Bond ETF (IEMB), the first emerging market debt ETF launched in Europe, is a clear market leader with assets under management close to $2 billion. To put that in perspective, over 60% of assets in the entire range of emerging fixed income ETFs are held inside this specific ETF. Liquidity is an important consideration when choosing an ETF and so this ETF has a clear edge over its competitors. However, amongst these, the db x-trackers II EM Liquid EuroBond ETF (DXSU), which is hedged in EUR, could be seen as a more interesting proposition for investors – admittedly only those in the eurozone – unwilling or unable to deal with foreign exchange considerations.  

Below is a list of ETFs available in this category:

 

Local Currency Emerging Market Government Bond ETFs
The shift in risk perceptions over the past decade has allowed emerging market governments to roll out local currency bond issuance programmes. The maturity of these bonds tends to be shorter compared to USD-denominated bonds. The attraction of local currency emerging market bonds rests on the twin pillars of relatively high yields and currency gains, with the latter having increasing influence over returns since the outset of the global crisis. In our view, currency issues pose the main risk to investors. For all the talk of development of internal sources of growth, emerging markets remain fundamentally geared towards exports. This requires competitive exchange rates. Investors in these products need to be aware that emerging governments are not averse to implementing ad-hoc policy measures to arrest/reverse local currency appreciation.   

There are currently five ETFs trading on European exchanges, three of which offer exposure to the wider emerging market universe (e.g. Asia, Latin America, Emerging Europe) and two focus solely on Asian countries. The base currency for these ETFs is USD, which translates into a three-way FX angle for UK and European investors (e.g. USD-denominated creation/redemptions to buy/sell local currency emerging market bonds in an ETF that trades in EUR or GBP on the European exchanges). The SPDR BarCap EM Local Bond ETF (SYBM) and the iShares BarCap EM Local Government Bond ETF (IEML) are the most popular based on assets under management. It is worth stressing that the level of market exposure offered by these ETFs is not uniform as they track different indices with different rules on bond and country eligibility. (To learn more about this, read the article New Ways to Access Emerging Market Debt, which provides a detailed explanation of the differences between the three wider local currency emerging market bond ETFs.)

Below is a list of the ETFs in this category:

Emerging Market Corporate Bond ETFs
The most recent addition to the European-domiciled emerging market debt ETF universe is that of corporate bond market exposure. Emerging market corporate bond issuance is generally undertaken in USD and with average maturity in the 5-10 year range. Issuance in this market is typically dominated by large multinational firms (e.g. big energy groups such as Petrobras) with respectable credit quality. Currently, the iShares Morningstar USD EM Corporate Bond ETF (EMCP), launched in April 2012, remains the only ETF providing access to this market segment. It does so by tracking the performance of the Morningstar EM Corporate Bond Index. This index does not discriminate in relation to rating, although around 80% of its components are rated investment-grade, with only 20% classed as “high yield” (ie. non-investment grade). Excluding the “high yield” segment, emerging market corporate bond yields are similar to those offered by USD-denominated emerging market government bonds.

The Future of Emerging Market Bond ETFs
The emerging debt ETF market in Europe has grown significantly, and we at Morningstar expect further growth in the future. The US ETF market, which is much more developed in this field, offers good clues as to where the European ETF providers might go next. We anticipate ETFs will soon be launched offering exposure to just the high yield segment of the emerging corporate bond market. We may also see more “exotic” exposures such as Dim Sum bonds (e.g. Chinese yuan-denominated bonds that trade in Hong Kong). Another area of development could be that of maturity-delimited exposures, which would allow investors to fine-tune portfolio risk management.  

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About Author Jose Garcia-Zarate

Jose Garcia-Zarate  is a senior ETF analyst with Morningstar Europe.