Exchange traded funds offer investors the opportunity to gain access to a greater pool of assets. Emerging market securities used to be limited to large institutional investors who had the means to gain exposure to far, out-of-the-way markets. However, ETFs have become the great equalizer, bringing alternative assets to the retail investor. Along with easier access to developing market equities, individuals are now able to tap into emerging market debt with ETFs.
The market for debt in emerging countries has come a long way, developing into a viable asset class that investors can access with relative ease. Apart from the robust growth rates and cleaner balance sheets, many developing economies have improved their economic, legal and regulatory systems, bringing greater stability to their markets.
Emerging market bonds, or fixed-income debt, are issued by developing countries and their domestic companies. Credit quality has improved over the years, but emerging markets are still seen as higher credit risks than their developed counterparts – most investment ratings firms have kept emerging market credit quality at non-investment grade, speculative ratings or lower. Of course, the higher risk also comes with the potential for higher returns. While credit risk and potential defaults are large considerations when choosing bonds from the developing side of the world, emerging economies have dramatically reduced their debt levels to around 50% of their gross domestic product and lower, compared to European and the U.S. which sit at around 100% of debt-to-GDP and Japan at above 200% debt-to-GDP.
Before investing in an emerging market bond ETFs, investors should determine whether or not the bond ETF is dominated in the local currency. Some funds hedge their foreign currency exposure, so investors in these ETFs don’t need to worry about whether the Brazilian real or the Indian rupee is weakening versus the dollar.
Accessing emerging market sovereign debt has traditionally been quite difficult. At one time, retail investors could only gain exposure to emerging market debt through expensive mutual funds, which required hefty minimums. However, the ETF industry has launched a handful of portfolios tracking emerging market bonds, denominated in both the local currency and in U.S. dollars, some of which have already attracted hundreds of millions in assets.
Emerging Market Debt ETFs
Invesco PowerShares and BlackRock’s ETF division, iShares, were the first to introduce emerging market bond funds. The PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY) and the iShares JPMorgan USD Emerging Markets Bond Fund (NYSEArca: EMB) both began trading in 2007. Since both funds track U.S.-denominated emerging market debt, investors should not have to worry about foreign currency risk – the direct affect movements in the forex market may have on the funds’ performance.
EMB tracks the JPMorgan EMBI Global Core Index, which also follows U.S.-denominated emerging market debt. The fund has $3.5 billion in assets, an expense ratio 0.60% and yields around 4.9%. The ETF follows a market-value-weighted strategy, which means that the countries with the most amount of outstanding debt will have a larger weighting within the index, but it does limit weightings at 8%. Top country allocations include Mexico at 7.9%, Brazil at 7.8%, Russia at 7.8%, Turkey at 6.9% and the Philippines at 6.9%.