The increasingly leveraged emerging markets may leave developing economies, along with related bond exchange traded funds, open to rising default risks.

As the U.S. dollar strengthens against the U.S. dollar, some bond observers have issued a warning on emerging market bonds denominated in USD, arguing that the stronger dollar would make it harder for emerging market borrowers to service debts.

Consequently, the fears may have weighed on USD emerging market bond ETFs, such as the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEArca: EMB) and PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY), which dipped 0.6% and 0.8% year-to-date, respectively.

Other fixed-income watchers are concerned about emerging market bonds denominated in their local currencies as well. Jesse Schreger of Harvard University and Wenxin Du of the Federal Reserve Board recently wrote a paper, contending that investors should also be worried about local currency bonds issued by EM sovereigns, reports Jonathan Wheatley for the Financial Times.

The two authors point out that while sovereigns have diminished their foreign currency liabilities – about 60% of debt is in local currency whereas 85% was in foreign currencies a decade ago, emerging corporations have been on a foreign currency borrowing spree. If the borrowers are unable to service the debt in a stronger USD environment, “a depreciation could adversely affect firm net worth, which in turn could reduce aggregate out,” according to the authors. Consequently, the weakness would add to additional default risk on local currency sovereign debt.

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