By now, most investors know emerging markets stocks and exchange traded funds have been turning in another batch of dismal performances this year. Investors also know that emerging markets fixed income funds are supposed to be vulnerable to changes in U.S. interest rate policy.
However, those changes have yet to materialize and ETFs such as the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEArca: EMB) and PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY) have been far superior to their equity-based counterparts this year.
With the U.S. dollar rising against a slew of emerging markets currencies, 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.
While many emerging markets have garnered a bad reputation for experiencing spiraling debt defaults in face of rapid currency depreciation, the developing economies are more resilient in a weak commodities environment.
According to BlackRock, emerging market governments have accumulated less dollar debt, built up foreign reserves and adopted flexible exchange rates to obviate mistakes during the 1980s and 1990s crises. Though the current outlook for emerging markets debt is far from sanguine, some analysts see opportunity in the asset class. [Investors Turn to Emerging Market Bond ETFs for Higher Yields]
“Bigger debtors should keep paying their bills through the current slowdown, despite jarring downgrades to junk this year for once-prized issuers like Russia and Brazil,” reports Craig Mellow for Barron’s.
The attractive emerging market bond yields, though, are not without their risks. For example, many fixed-income observers are closely watching the Federal Reserve’s monetary policy. A Fed rate hike could cause a large exit out of emerging market assets in favor of better returns in the U.S.
However, it should be noted that most of the bonds held by EMB and PCY, the two largest emerging markets bond ETFs, are rated well into investment-grade territory.
“Another change stabilizing emerging markets on a macro level has been a mass shift from pegged to floating currencies, which act as a shock absorber in tough times. Instead of the abrupt meltdowns that afflicted the Korean won, Thai baht, or Mexican peso in crises of yore, EM currencies have lost altitude gradually since mid-2011, scraping 15-year lows against the dollar,” according to Barron’s.
iShares J.P. Morgan USD Emerging Markets Bond ETF
Tom Lydon’s clients own shares of EMB.