ETF Trends
ETF Trends

After several months of not hearing much about emerging market (EM) bonds (other than “Where’s the exit?”), we have recently been fielding questions on whether there is value in this space. A key focus is the relative value of USD denominated EM debt relative to other fixed income sectors, which I discussed in a Blog post last quarter.

Let’s review the basics. A lot of investors evaluate fixed income sectors by looking at the level of yield they might receive for a given level of risk. We continue to explore how investors consider interest rate risk and portfolio positioning in the current environment. In addition to interest rate risk, there is substantial emphasis on the yields available for different levels of credit risk, which is essentially the risk that an issuer will not make regular coupon payments or will not be able to pay back principal. Credit ratings provided by third party agencies like S&P and Moody’s are often used as a way of gauging the credit risk of an issuer. It essentially measures a debtor’s ability to service and pay back its obligations.

At a high level, bonds are divided into two major categories: investment grade and high yield. Investment grade is defined as ratings at or above BBB- for S&P or Baa3 from Moody’s, and high yield is defined as ratings below those levels. Many of the fixed income ETFs in the market provide exposure to either investment grade or high yield debt. For example, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), our flagship Investment Grade Corporate exposure ETF, provides exposure to higher quality corporate bonds while the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), our flagship high yield ETF, provides exposure to lower rated corporate issuers.

As we know from the risk-return tradeoff, the higher the level of credit risk an issue has the higher the yield will likely be. Credit risk is often measured with a metric called Option Adjusted Spread or OAS, which considers the additional yield an investor is paid over and above the yield on a similar Treasury security. If we compare the credit spreads of different corporate ETFs to their fund ratings we find a typical upward sloping curve that reflects the fact that investors will require more yield to compensate for higher levels of credit risk.

Here is an illustration of this relationship using ETFs with a range of levels of credit risk:

Source: BlackRock as of 5/9/2014
For more information on S&P fund credit ratings, please click here.

At the far left of the graph is the iShares Aaa-A Rated Corporate Bond ETF, QLTA. This fund primarily provides exposures to securities with ratings of A or higher. At the far right of the graph is the iShares B-Ca Rated Corporate Bond ETF, (QLTC). This fund provides exposure to the lower credit quality segments of the high yield market, and because of the level of credit risk in the fund, it offers the highest yields of the group.

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