The combination of emerging markets and junk bonds may appear to be too risky for many income investors, but with the right methodology investors can dial back some of that risk while grabbing access to higher levels of income.
Enter the VanEck Vectors EM High Yield Bond ETF (NYSEArca: HYEM). HYEM seeks to replicate the ICE BofAML Diversified High Yield US Emerging Markets Corporate Plus Index, which is comprised of U.S. dollar denominated bonds issued by non-sovereign emerging market issuers that have a below investment grade rating and that are issued in the major domestic and Eurobond markets.
Amid low interest rates in the United States and inklings of the reflation trade taking shape, HYEM is a credible near-term consideration for income-starved investors.
“Reflation has, again, become a dominant theme driving fixed income markets, and the bond market has been flashing signals on expected growth an inflation,” writes William Sokol, VanEck senior ETF product manager. “The yield curve is at its steepest level since mid-2017, when measuring the difference between the 10-year and 2-year yield. In terms of inflation, breakeven inflation (the difference between the 10-year nominal rate and 10-year TIPS, which measures the market’s expectation for inflation) reached its highest point in two years, now firmly above 2%.”
Income Help with the HYEM ETF
In recent years, some yield-starved investors embraced emerging markets debt as a way of increasing income. As the global economy continues to expand, many will increase consumption of raw materials to fuel the expansions, which in turn would support most of the emerging markets that help supply the raw commodities like oil and metals.
“Over the past decade, the correlation of U.S. and emerging markets high yield corporate bonds to inflation, although not strongly positive, is only slightly below that of U.S. equities and higher than investment grade bonds and U.S. Treasuries (which has a negative correlation),” notes Sokol.
Covid-19 turned fixed income investors away from emerging markets (EM) debt, but they could be coming back. As the pandemic wanes in some countries, more investors could be willing to embrace the heightened risk when it comes to EM bonds.
“In addition to diversification, emerging markets high yield corporate bonds also provide a compelling relative value opportunity within a global high yield portfolio,” adds Sokol. “The asset class currently provides a yield that is 1.23% higher than U.S. high yield bonds (as of January 31, 2021), driven by a pickup in credit spreads that is above the 5-year average. Average effective duration is lower (3.55 versus 3.80), potentially providing additional cushion if rates continue to rise.”
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