Emerging market bond exchange traded fund investors should consider sticking to U.S. dollar-denominated sovereign debt as these types of debt securities would ride out currency risks associated with an appreciating greenback.
For instance, the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEArca: EMB) and the PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY) both track USD-denominated emerging market bond securities.
EMB has a 0.60% expense ratio and comes with a 4.51% 30-day SEC yield. PCY has a 0.50% expense ratio and a 4.82% 30-day SEC yield.
“Both the PowerShares and iShares emerging-markets bond exchange-traded funds hold only U.S.-dollar-denominated bonds,” according to Morningstar analyst Patricia Oey. “As such, they do not have any direct foreign-currency exposure.”
In comparison, local-currency-denominated bonds are exposed to currency risks, so a depreciating emerging market currency would translate into a lower U.S.-dollar return. [Diversifying With EM Bond ETFs]
“This foreign-currency exposure can provide a boost if emerging-markets currencies appreciate against the U.S. dollar, but can be a downer if they slide versus the greenback,” Oey added.
However, since countries with weak fundamentals typically issue hard-currency debt, or bonds denominated in strong, safe-haven currencies. Consequently, U.S. dollar-denomianted emerging market bonds may carry lower credit ratings and are relatively more volatile. While the emerging markets may be associated with higher risks, the EM bond funds include some investment-grade debt exposure.
EMG’s credit quality includes AA 4.5%, A 15.9%, BBB 46.8%, BB 8.1%, B 5.2%, below B 8.6% and not-rated 10.9%. PCY’s credit quality includes AAA 0.8%, AA 4.5%, A 16.9%, BBB 48.1%, BB 17.6%, B 4.3% and below B 7.9%.
Looking ahead, emerging market bond investors should watch out for global volatility or deteriorating fundamentals in the developing economies, which can trigger sudden outflows from the market. Oey points out that capital flight will negatively affect the short-term performance of these funds.
iShares J.P. Morgan USD Emerging Markets Bond ETF
For more information on the fixed-income market, visit our bond ETFs category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.