My Favorite ETF for Gaining Exposure to High-Yield Emerging Market Debt

When renowned fund manager Bill Gross talks about finding the cleanest dirty shirts, he’s clearly only looking in the developed world. Stepping outside the usual hunting grounds of the US, Europe and Japan (the G-3), you can find any number of countries with low debt-to-gross domestic product (GDP) ratios, budget surpluses, strong credit ratings and steadily growing economies.

Gross public sector debt as a percentage of the G-3’s GDP is about 110 percent, versus just less than 50 percent in Latin America and about 30 percent in emerging Asia and Europe. Foreign reserves in the emerging world are also nearly twice that of developed countries, at nearly USD6 trillion. At the same time, while the G-7 economies aren’t likely to manage growth much better than 2 percent over the next three years, emerging market economiesare expected to grow by better than 6 percent over the same period.

Many emerging market countries are better off fiscally than most of the developed world, but they’re still forced to offer higher coupon rates than developed world debt thanks to their emerging market status. While the US is able to get away with paying a pittance on Treasury bonds, on average an emerging market sovereign bond carries an average coupon of 5 percent.

Individual bond issues are available for trade on the global markets, but most are fairly illiquid and can be tough for retail investors to get their hands on at a reasonable cost. Given the high transaction costs, trading individual emerging market bonds is still largely the purview of institutional investors.

But there are several exchange-traded funds(ETFs) available that make it easy for American retail investors to trade emerging market debt.

Market Vectors Emerging Market Local Currency Bond ETF EMLC has long been my favorite vehicle for getting emerging market debt exposure.

The fund holds only sovereign fixed-rate bonds with more than a year left to maturity, issued by countries defined by the World Bank as low or middle income.

Within the portfolio are about 200 individual bonds issued by 15 countries, with Brazil, Poland, South Africa and Mexico receiving allocations at 10 percent of assets each. More than 60 percent of the bonds in the fund are rated BBB or better by the major credit rating agencies, with 16.8 percent rated below investment grade and about 22.3 percent not rated at all. Overall, the fund’s average credit quality is BB with an average maturity of 7.3 years.

With the exception of Hungary and Brazil, all of the countries represented have markedly lower debt than their developed world peers.

On average the fund’s portfolio countries are expected to generate better than 5 percent GDP growth this year and better than 6 percent in 2013, largely because their economies are generally insulated from the developed world’s woes.

Most of these countries are paragons of political stability, although tensions linger in Nigeria and Russia. In Colombia, the government is in the early stages of peace negotiations with the Revolutionary Armed Forces of Colombia (FARC), a socialist rebel group that has been responsible for sporadic attacks and fighting since the 1960s. The talks have brought relative quiet to the country.

In addition to offering fixed-income exposure to countries that are economically strong and politically stable, the fund is also a useful tool for diversifying currency exposure. It only purchases bonds issued in local currencies and doesn’t hedge its currency exposure vis-à-vis the US dollar, giving investors an additional tailwind when the dollar declines (although it’s a headwind when the dollar is strengthening). Buying foreign bonds is inherently a currency play, so I fail to see the advantage of hedging away currency risk.

Currently yielding 4.4 percent, Market Vectors Emerging Market Local Currency Bond ETF is a solid long-term play to gain diversified emerging markets exposure. For individual emerging market picks, see my free report.