Be Wary of Emerging Market Bonds

Compared with their developed counterparts, emerging markets bond ETFs are riskier, typically more illiquid and with higher transaction costs

Jose Garcia Zarate 23 September, 2019 | 9:20AM
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EM bonds

Emerging market bonds are amongst the most popular ETF investment categories so far this year. Net flows into US dollar denominated emerging market bond ETFs have totalled £2.4 billion by the end of August, while local currency emerging bond ETFs attracted £1.16 billion.

The appeal is understandable. As many developed government bond markets fall deeper into negative yield terrain, investors have been keen to search for the remaining pockets of the fixed income market still functioning normally. Meanwhile, the ease of use of ETFs has lent itself well for investors to quickly lock in positions and increase exposure to the asset class in investment portfolios.

Compared with their developed counterparts, emerging markets bonds are riskier, typically more illiquid and with higher transaction costs. Investors should not to treat this as a homogeneous asset class and instead discriminate between issuing countries. On paper, this would support an active approach to the asset class, as active managers may be able to pick the right bets in terms of country exposure. However, active bets on emerging markets debt remain fraught with risks, whereas a geographical broad-based and low-cost passive approach can help balance these out over the long-term.

It would be a mistake to think that all emerging market bond ETFs offer exposure to the asset class in the same manner. In fact, currently, all European-domiciled emerging market bond ETFs track different indices. This applies to indices from different providers and also to different indices created by the same provider.

When it comes to ETFs, different indices often mean different investment propositions even when providing exposure to the same market. In the case of emerging market bonds, each of the indices tracked by these ETFs applies a specific set of eligibility criteria. Some indices have high liquidity hurdles for bonds and issuing countries. By contrast, other indices adopt a more flexible approach to boost diversification and enhance yield generation potential.

Different rules of construction result in variations in the baskets of constituents. In turn, this can translate into different performance patterns in the short to mid-term. A very recent example of this took place in August when Argentina’s bond market experienced a sharp decline as investors took fright of domestic political risks.

Cry for Me, Argentina 

Whenever Argentina makes top headlines in financial news, investors expect trouble.  The country, which according to a report from the World Bank released earlier in 2019, has spent one-third of the time since 1950 in recession, is no stranger to sovereign defaults. In August, international investors were wrongfooted by the unexpected defeat of President Macri to rival Alberto Fernandez in the primary presidential elections held on 11 August. Now widely tipped to win the actual presidential contest in October 27, Fernandez is playing populist and has promised to play hard ball with the IMF and engage in widespread public spending programmes. International investors smell trouble.

In August, the allocation to Argentina in the emerging market bond indices tracked by all-maturity ETFs ranged from a 0% in the JP Morgan Risk Aware index tracked by JPM USD Emerging Mkts Sov Bd ETF to 6.2% in the Markit iBoxx USD Liquid EM Sovereign index tracked by Amundi IS Global Emerging Bond Market IBOXX ETF and Lyxor iBoxx $ Liquid EM Sovereign ETF.

This resulted in different performance patterns during the month. The index with the highest exposure to Argentina saw stronger gains in the run-up to the primary election date and experienced a sharp downside once the results came in. So sharp in fact, that it remained stuck in negative terrain for the remainder of the month. 

These short-term variations in performance between indices may well balance out over the long-term. What acts as a drag one month can turn into a key driver of growth the next. Still, examples like this serve to reinforce the message that not all indices are created equal.  When it comes to ETFs the number one task in investors' due diligence must be to understand what the index offers us.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Jose Garcia Zarate

Jose Garcia Zarate  is Associate Director of Passive Strategies Research for Morningstar Europe