ETF Trends
ETF Trends

The quickly appreciating U.S. dollar could increase default risks in emerging market bond exchange traded funds that track USD-denominated securities as countries find it harder to pay back the debt.

For instance, the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEArca: EMB) and PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY) both track a portfolio of U.S.-dollar-denominated emerging market bonds. [Mind Your Global ETF’s Currency Exposure]

The market for emerging-market corporate bonds denominated in U.S. dollars has swelled over the years, fueled by income-hungry investors in a low-yield environment, Carolyn Cui reports for the Wall Street Journal.

However, investors may get burned if prices fall off, similarly to what happened late last year on concerns over companies’ ability to service the debt in a strengthening USD environment after more have piled into the USD-denominated emerging market bond funds to capture the rebound this year.

For instance, EMB has attracted $307.3 million in net inflows so far this year, according to ETF.com, while the ETF rose 4.4% year-to-date.

“In countries where we’ll have a significant economic slowdown, an increase of defaults will put strains on the banking sector and potentially trigger a macro event,” Bryan Carter, an emerging-market debt manager at Acadian Asset Management, said in the WSJ article.

For instance, Kaisa Group Holdings, a major real estate company, defaulted on its U.S.-currency debt, raising concern that defaults will spread, Bloomberg reports. China makes up 4.1% of EMB’s underlying holdings.

Looking ahead, if the Federal Reserve hikes rates, emerging market companies that borrowed overseas are more susceptible to foreign capital swings and could find it more difficult to refinance debt. Moreover, a strengthening USD makes it costlier to pay off dollar-denominated bonds.

“What’s at risk is not the country.…It’s the credit risk of the corporates,” Jan Loeys, chief investment strategist for J.P. Morgan, said in the WSJ article.

J.P. Morgan anticipates default rates among emerging-market high-yield corporate issuers to hit 5.4% this year from 3.2% in 2014. In contrast, Fitch Ratings calculates that less than 2% of U.S. junk bonds are expected to default this year.

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. Tom Lydon’s clients own shares of EMB.

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.