Emerging market bond ETFs have grown in popularity the past year as investors broaden their horizons in the fixed-income markets in the search for yield.
However, a pair of emerging market debt ETFs in this fast-growing category has been beating the competition recently in terms of performance.
They are outperforming because they don’t hedge their foreign-currency exposure,and a strengthening U.S. dollar is providing a tailwind.
The iShares JP Morgan USD Emerging Markets Bond Fund (NYSEArca: EMB) and PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY) avoid foreign-currency risk by investing in dollar-denominated debt.
Over the past three months, EMB and PCY have delivered total returns of 4.6% and 6%, respectively, according to Morningstar. WisdomTree Emerging Markets Local Debt (NYSEArca: ELD), which does not hedge its foreign-currency exposure, is flat over the same period.
EMB and PCY are getting a lift from a stronger U.S. dollar on Eurozone debt worries and a preference for safer currencies. PowerShares DB US Dollar Index Bullish (NYSEArca: UUP) is up 3.8% for the trailing three months. [Emerging Market Bond ETFs that Hedge Currency Risks]
EMB is larger in terms of assets with $4.8 billion. The fund has a 30-day SEC yield of 4.3%, according to manager BlackRock.
PCY, the PowerShares ETF, holds assets of about $2 billion and offers a 30-day SEC yield of 5%.
EMB and PCY have expense ratios of 0.6% and 0.5%, respectively.
“EMB owns only U.S.-dollar-denominated bonds, so there is no direct currency exposure. This eliminates a risk, but some investors would probably prefer to have the foreign currency risk, because it could increase returns if the U.S. dollar falls versus emerging-markets currencies,” says Morningstar’s Timothy Strauts in an analyst report on the ETF. “The fund only invests in U.S.-dollar-denominated bonds because it improves the liquidity of the portfolio. Foreign-denominated bonds in many cases trade very infrequently.”
Strauts notes that PCY equal-weights its portfolio so countries with higher debt levels do not get higher allocation in the fund, which should reduce risk over the long term.
iShares JP Morgan USD Emerging Markets Bond Fund
PowerShares DB US Dollar Index Bullish
Full disclosure: Tom Lydon’s clients own EMB.