Yield-starved investors have taken a shine to emerging markets bond exchange traded funds in recent years. Funds such as the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEArca: EMB) have made the asset class more accessible but that access does not come without challenges.
EMB tracks the J.P. Morgan EMBI Global Core Index, a market-cap-weighted index. Potential investors should note that since it is a cap-weighted index, countries with greater debt will have a larger position in the portfolio.
Emerging market bond investors should analyze concentration risk or look under the hood of their funds to better understand how much of a particular investment they are exposed to.
Previous Fed rate hikes have triggered volatility in the emerging markets. 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.
“Debt issued by governments and companies in emerging economies can be harder to buy and sell. Higher transaction costs have resulted in tracking errors in emerging-market bond ETFs. The complexity of these bonds, particularly those of far-flung markets, can also give an edge to active bond managers, who in some cases have spent decades gaining an understanding of idiosyncratic political and currency risks,” reports Carolyn Cui for the Wall Street Journal.
The PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY), another dollar-denominated ETF, is another emerging markets bond ETF to consider.
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.
PCY, which has a 30-day SEC yield of just under 5.3% and a modified duration of 8.5 years, features some exposure to Central European and African economies.
Active managers have been vocal critics of emerging markets bond ETFs. In some cases, these managers highlight tracking error of passive products as a potential problem for investors.
“Still, some active managers say ETFs are flawed products for these investments and can’t properly replicate indexes. Because of liquidity constraints, ETF providers tend to own the more liquid bonds as a proxy for the entire market. That has led prices of certain bonds that are ETF constituents to become more costly as flows of cash increase—a circumstance that has emerged with some Russian and Indonesian bonds this year,” according to the Journal.
For more information on the fixed-income market, visit our bond ETFs category.
Tom Lydon’s clients own shares of EMB.