Investors who are using emerging market bond exchange traded funds to supplement their income needs should understand the potential risks of being exposed to this foreign debt asset.
On Wednesday, emerging market borrowing costs hit their highest level in five years as investors warned of a crippling credit crunch, the Financial Times reports.
The weakness is being fueled by depreciating local currencies, notably from commodity-producing countries, that have raised the borrowing cost of U.S. dollar-denominated debt.
“A credit crunch is a concern,” Franck Nicolas, head of investment at France’s Natixis Asset Management, told the Financial Times. “The worldwide demand for emerging market assets was huge and inflated a lot of assets. Now the situation is changing.”
Commodity-exporting country debt led the retreat while currencies like the Brazilian real, Mexican peso, South African rand and Russian ruble depreciated against the U.S. dollar. Consequently, the average government borrowing costs in dollars have hit 6.7%, or up from 5.3% last year.
“Emerging and developing countries are now confronted with a new reality,” IMF Managing Director Christine Lagarde warned central bankers this month, according to Wall Street Journal. “Another bout of global risk aversion could lead to further commodity price declines…and depreciating exchange rates.”
For fixed-income investors, emerging market debt may provide more attractive yield opportunities, but they also come with indirect currency risks and rising credit risks. For instance, the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEArca: EMB), PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY) and Vanguard Emerging Markets Government Bond ETF (NasdaqGM: VWOB) all track USD-denominated emerging market debt. Consequently, a strengthening U.S. dollar or weakening emerging market currencies will make it harder for debt issuers to repay the dollar-denominated debt.
The emerging market bond ETFs include significant exposure to some of the weakest emerging market currencies. Among its top holdings, EMB includes Mexico 6.5%, Russia 5.6%, Brazil 4.0% and South Africa 3.4%. PCY holds Russia 4.0% and other emerging eastern European countries among its top holdings. VWOB includes Mexico 8.3%, Brazil 7.3%, Russia 7.2% and South Africa 1.5%.
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.