Despite the stronger dollar, long believed to be problematic for developing world debt issuers, some emerging markets bond exchange traded funds have been sturdy this year.

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 dollar makes it costlier to pay off dollar-denominated bonds.

With the specter of rising rates increasing, proper evaluation of emerging markets bond funds takes on heightened importance. That means avoiding the ETFs with heavy exposure to the largest countries with the biggest debt loads. The PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY) can help investors skirt some of the pitfalls of investing in developing world bonds. [Opportunity With EM Bond ETFs]

PCY is one of a small but growing number of bond ETFs that legitimately lay claim to the smart beta designation. The $2.53 billion fund, the second-largest emerging markets bond ETF, is almost eight years old and carries a four-star rating from Morningstar.

“PCY differs from traditional market-cap-weighted exchange-traded funds by applying a valuation screen and using equal country weightings. The fund uses bond z-spreads to screen for the three most undervalued sovereign bonds in each of its index’s 25-country universe. The z-spread calculates a bond’s discounted future cash flow across the yield curve instead of just at maturity,” writes Thomas Boccellari for Morningstar.

PCY’s weighting methodology leads to significant differences at the country level when compared to rivals, such as the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEArca: EMB). [Mind Global Currency Exposure in ETFs]

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