Fixed-income investors who are looking to adapt to changing market conditions may consider factor ETF investing in bond markets and how an allocation to emerging markets can potentially boost yield and increase diversification, without a meaningful increase in duration.
On the recent webcast (available on demand for CE credit), Beyond Factor Fundamentals – Are You Factoring in EM Debt?, David M. Lebovitz, Global Market Strategist for J.P. Morgan Asset Management, highlighted the promising global growth outlook, with the global Purchasing Managers’ Index for manufacturing hovering around 53.4 at the end of last month – readings above 50 indicate an expansion.
Due to the positive growth, strengthening economy, rising inflationary outlook and low unemployment rates, the Federal Reserve should continue to hike interest rates gradually, which could mean pain for high quality bonds, Lebovitz warned. Fixed-income investors who are tracking traditional benchmarks like the Bloomberg Barclays U.S. Aggregate Bond index are now exposed to greater risks with less payouts. Specifically, the Agg showed a 3.12% yield and a 6.1 year duration as the end of last month, but it averaged a 5.20% yield and a 4.8 year duration, which goes to show the greater rate risk and lower yield for the higher risk that investors are now exposed to.
Related: J.P. Morgan Rolls Out a Smart Beta Emerging Market Bond ETF
Nevertheless, the U.S. bond market is not the only area that fixed-income investors need to rely on. The U.S. use to make up 61.3% of the global bond market back in 1989, but it is now 36.7% of the total market. On the other hand, developed ex-U.S. makes up 42.7% and emerging market bonds account for 20.6% of the total bond market, but many investor portfolios fall short of this global breakdown.
Moreover, by excluding foreign exposure and focusing solely on U.S. bonds, fixed-income investors may be missing out on attractive yield opportunities. As of the end of March, U.S. aggregate bonds showed a 3.12% yield, but areas like emerging market dollar-denominated debt showed a 5.76% yield, emerging market local currency debt showed a 6.01% yield and emerging corporate bond yields had a 5.05% yield.
Eric Isenberg, Head of Fixed Income Portfolio Management at J.P. Morgan Asset Management, pointed out that the emerging bond category has become more mature and attracted greater investment interest after expanding to $79 billion from $12 billion over the past decade. Investors are also beginning to tap into this emerging bond market through passive products as index-based fund investments gain in popularity.
However, despite this growth, challenges still exist when investing in emerging market debt, Isenberg warned, specifically pointing to risks like investability concerns, credit risk and rate sensitivity. There may be many small countries and bonds that do not necessarily impact returns but can significantly impact transaction costs. A number of so-called debt crisis have littered the developing economies over the years, serving to warn investors of some of the inherent risks associated with emerging markets. Emerging market debt has also seen credit ratings improve over the years, which has allowed many to issue longer dated debt that would extend the duration of their bonds. When investors want to diversify and potentially tap into the high-yield opportunity of emerging market debt, these things need to be factored in.
J.P. Morgan has tried to make the emerging market bond investment process easier with the the recently launched JPMorgan USD Emerging Markets Sovereign Bond ETF (NYSEArcaL: JPMB), which tries to reflect the performance of the rules-based JPMorgan Emerging Markets Risk-Aware Bond Index, includes liquidity, risk and credit screens to filter out some of the more questionable debt securities in an inherently riskier global market segment.
Through this alternative weighting approach, the index seeks to provide better risk-adjusted returns compared to traditional market cap-weighted indexing and to potentially generate a competitive yield with lower levels of duration for investors.
While JPMB is new and some traders may be loath to execute large orders on a relatively slowly traded vehicle, Ryan Szakacs, Vice President of ETF Capital Markets for J.P. Morgan Asset Management, explained that financial advisors ore investors seeking large trade orders may work with their trading desks or J.P. Morgan’s capital markets team to push through efficient trades. The ETF’s true liquidity reflects its underlying markets, which is comprised of 93% sovereign debt and 7% quasi-sovereigns, with a daily capacity of $300 million.
Szakacs also explained some best practices for pushing through a trade order, such as utilizing limit orders to improve pricing, especially when the secondary market liquidity is a concern. Investors should also avoid trading at the open or close of market trading as the first and last 15 minute periods of the day are usually more volatile.
Financial advisors who want to learning more about the EM debt market can watch the webcast here on demand.