Helped by declining Treasury yields, fixed income exchange traded funds holding emerging markets debt have been solid performers this year, rebounding from a disastrous 2013 that saw investors flee the asset class.
In the second quarter, the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEArca: EMB) pulled in $1.2 billion in new assets while the rival PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY) added $203 million. [iShares Leads Q2 Flows]
EMB and PCY are up 6.1% and 7.5% year-to-date, respectively. The resurgence of emerging markets bonds has helped lift ETFs holding developing world stocks, making ETFs such as the iShares MSCI Emerging Markets ETF (NYSEArca: EEM) among the second quarter’s best asset gatherers. Notably, emerging markets bond funds have rebounded in the face of heavy new issuance and credit downgrades for Brazil and Russia.
Emerging markets borrowers sold over $260 billion in new debt in the first half of this year with $60 billion coming from sovereign borrowers and $200 billion from corporations, Reuters reports, citing J.P. Morgan data.
Speculation that the Federal Reserve could raise interest rates early next year is believed to be the catalyst for the flurry of new issuance. After speculation that the Fed would taper its bond-buying efforts surfaced last year, investors rushed to pull capital from ETFs like EMB and PCY. [A Lift for EM Bond ETFs]
Emerging markets bond ETFs have admirably dealt with sovereign downgrades for Brazil and Russia, often two of the largest country weights in those ETFs. For example, the ProShares Short Term USD Emerging Market Bond ETF (NYSEArca: EMSH), which allocated over 19% of its combined weight to Russian and Ukraine debt at the end of the first quarter, posted a 1.5% second-quarter gain. EMSH has a 30-day SEC of 4.1% and a duration of 2.24 years.
The Russia-Ukraine conflict slowed issuance by Russian corporates, usually among the most prolific emerging markets issuers of corporate debt. Russian bond sales total just $7 billion this year after reaching $25 billion in the first half of 2013, Reuters reported.
That has not derailed the WisdomTree Emerging Markets Corporate Bond Fund (NasdaqGM: EMCB). The $101.1 million EMCB surged 4.6% in the second quarter. EMCB allocates 21% of its weight to Russia. The ETF has a 30-day SEC yield of 4.64% and an effective duration of 5.13 years. More than two-thirds of EMCB’s underlying index is allocated to investment-grade holdings.
“EM corporates presently trade at a yield premium to B-rated U.S. corporates. Prior to last year’s sell-off, yields for EM corporates have historically traded more in line with Ba-rated credits. Yields for Ba corporates as of 5/31/2014 are 4.16%, a full 115 basis points lower than CEMBI. The wider spreads are representative of more attractive valuations in EM corporates,” said WisdomTree in a recent research note.
Just over a quarter of this year’s newly issued emerging markets corporates have been junk-rated compared to a usual rate of 33%, according to Reuters.
That could be a sign that while investors like the yield advantage of developing world corporates, they are only willing to reach so far to get it.
About 81% of the SPDR Merrill Lynch Emerging Markets Corporate Bond ETF’s (NYSEArca: EMCD) weight is rated A or Baa. EMCD is heavy on Latin American corporate debt as Brazil and Mexico combine for 34% of the fund’s weight.
Some market participants believe Brazilian sovereigns are attractively valued while some have also noted that on a yield basis, Brazilian corporates are inexpensive compared to U.S. equivalents. EMCD has a 30-day SEC yield of 3.72% and a modified adjusted duration of 5.94 years. [Pimco Sees Value in Brazilian Bonds]
WisdomTree Emerging Markets Corporate Bond Fund
Tom Lydon’s clients own shares of EEM and EMB.