Surprising Bond Segment Can Help Shell-Shocked Fixed Income Investors

With emerging markets stocks and bonds of nearly all stripes, foreign and domestic, wilting as the Federal Reserve hikes interest, emerging markets bonds may seem like a bridge too far for many investors.

Boil it down to emerging markets corporate debt and many fixed income investors are likely to take a pass in this environment. However, they might want to reconsider that position because exchange traded funds such as the VanEck Vectors Emerging Markets High Yield Bond ETF (HYEM) are offering surprising value and opportunity.

The $1.1 billion HYEM follows the ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index and sports a tempting 30-day SEC yield of 7.88%. As its name implies, HYEM is a junk bond ETF and that’s enough to imply some level of risk, particularly when emerging markets are involved. However, emerging markets’ high-yield corporates may offer more diversification benefits than their investment-grade counterparts.

“The correlation between the U.S Agg. and Investment Grade EM bonds was 0.62, or nearly double that of the other EM sub-categories. This tighter correlation, combined with the narrow spreads, suggests to us that Investment Grade EM bonds do not differ all that much from the U.S. Agg. Index and investors looking to diversify away from the domestic bond market may want to pass on this particular option,” noted Leuthold Group’s Scott Opsal.

HYEM, which turned 10 years old earlier this month, has a yield to worst of 9.78%, according to issuer data. As Opsal pointed out, yield to worst is a relevant metric with emerging markets’ corporate debt because it can potentially highlight maturity mismatches.

“One driver of this spread pattern is a maturity mismatch. EM Corporates have a duration that is perhaps half that of sovereigns. This means the corporate yields represent shorter maturity issues which narrows the apparent gap with sovereigns. If we limited our universe to EM corporates of the same duration as sovereigns, we suspect the corporate curve would shift higher,” Opsal wrote.

HYEM has an effective duration of 3.78 years, indicating its rate risk is relatively low, while more than half the fund’s 756 holdings have maturities of one to three or three to five years. And while HYEM is a high-yield bond ETF, its credit risk isn’t excessive as less than 8% of its holdings are rated CCC or worse.

“The profile of EM Corporates, with their lower duration and better credit ratings, seem to be a particularly good fit to address today’s macro concerns. Local currency ETFs, despite their weak record over the last decade, could also prove interesting if the U.S. Dollar ends its strong run of late and begins to regress to previous levels,” concluded Opsal.

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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.