A Mixed Case for Some EM Bond ETFs

Since equity-based emerging markets exchange traded funds bottomed on Feb. 3, bond funds have been admirable performers.

The dollar-denominated iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEArca: EMB) and the PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY) are up an average of 6.2%. Both have recently been capturing new assets from investors. Helped by firming developing world currencies, the WisdomTree Emerging Markets Local Debt Fund (NYSEArca: ELD) and the Market Vectors Emerging Markets Local Currency Bond ETF (NYSEArca: EMLC) are up an average of 7% since Feb. 3. [Currency Rally Lifts These EM ETFs]

Market observers and portfolio managers have mixed views on emerging markets debt. Some believe yields are not yet high enough to justify the risks. Those with more optimistic views argue swaps and yield spreads have priced in scenarios for some emerging markets, including higher interest rates and increased default rates, that are unlikely to materialize.

Brazil is the center of the emerging markets bond debate. At 11%, the benchmark lending rate in Latin America’s largest economy is among the highest in the developing. The soaring Selic rate has helped prop up the once flailing Brazilian real, but last month, Standard & Poor’s lowered the country’s sovereign debt rating to BBB-, the lowest investment grade. The ratings agency did raise its outlook on Brazilian debt to stable from negative, which implies further downgrades from the ratings agency are unlikely in the near-term. [Brazil ETFs Survive S&P Downgrade]

Some investors are changing their tune regarding Brazilian bonds, including PIMCO, the world’s largest bond manager.

“Our main conclusion was that sentiment was so negative that markets had likely overshot and could improve from depressed levels given that relative value had finally become attractive,” PIMCO Deputy Chief Investment Officer Mark Kiesel said in a recent research piece. “We also felt the highly negative sentiment was overwhelming the market’s pricing of risk, which may have been ignoring numerous long-term strengths in Brazil. These include the country’s large and low-cost natural resource base, favorable demographics, healthy and well-regulated private sector banking system and democratic system where the government is gradually making progress on some fronts (e.g., airport and road concessions).

“Finally, the team felt that government approval ratings had deteriorated so much as a result of protests over rising prices, poor public services, a deteriorating fiscal deficit and government over-reach that negative opinion polls could be a positive catalyst for change.”

ETFs with decent exposure have been giving investors signals that perhaps the darkest clouds have passed Brazil’s credit and sovereign markets, a sentiment that applies to funds with exposure to real-denominated debt.

For example, the actively managed ELD is up 3.3% since the beginning of March. The passively managed EMLC is higher 3.6% over the same time. Brazil is ELD’s largest country weight at 10.8%. The ETF has an effective duration of 4.68 years. With an effective duration of 4.47 years, EMLC allocates 9.8% of its weight to real-denominated bonds, tying Brazil with Poland as the ETF’s largest country weights.