Market Overview

EM Local Debt ETFs Offer Opportunity

Equity-based emerging markets ETFs have languished through some rough performances in 2013, but their bond counterparts have tumbled mightily as well.

That goes for both dollar-denominated and local currency developing world debt. Year-to-date, the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSE: EMB) is down eight percent, a loss that is nearly twice as bad as that of iShares MSCI Emerging Markets ETF (NYSE: EEM).

"In the three months ending in July, local currency-denominated EM sovereign bonds fell 10.6%, U.S. dollar-denominated EM sovereign bonds declined 7.8%, and U.S. dollar-denominated EM corporate bonds dropped 5.8%., according to a research note published last month by PIMCO, the world's largest bond manager.

The specter of a reduction of or outright end to the Federal Reserve's quantitative easing forced many emerging markets currencies lower and bond yields higher, damaging local currency bond ETFs in the process. However, there are signs the environment for those ETFs could be improving.

Related: Finally, Some Hope For EM Bond ETFs.

"The possibility of a decline in the pace of Fed bond buying was cited as the primary catalyst for currency weakness and surging bond yields in emerging markets. Economies that once benefited from foreign investor flows have underperformed since flows began to reverse," said WisdomTree portfolio manager Rick Harper in a new research note. "However, we believe that those moves had overshot. With the recent FOMC meeting serving as a catalyst, we believe that locally denominated fixed income appears as an attractive way to play a less ‘hawkish' Fed."

A more sanguine tapering environment should be a boon for ETFs like the WisdomTree Emerging Markets Local Debt Fund (NYSE: ELD), the first actively manage ETF to cross the $1 billion in assets under management level. Underscoring the vulnerability of emerging markets local currency debt due to tapering talk, ELD has performed slightly worse than EMB this year, losing 8.5 percent.

ELD offers exposure to Brazil, Chile, Colombia, Mexico, Peru, Poland, Turkey, South Africa, Russia, Malaysia, Indonesia, Philippines, Thailand, China, and South Korea. The ETF's allocations to some of the most beaten-up developing world currencies is high as Brazil, Turkey, Thailand and Indonesia combine for about 31 percent of ELD's weight.

What is noteworthy about the taper-driven declines suffered by emerging markets debt is that many of those bonds wound up sporting higher yields than U.S. corporate junk.

"With some emerging markets being upgraded as recently as May 2013, we believe that only a select few pose a risk of a credit rating downgrade. However, EM local debt was recently offering the largest yield advantage compared to U.S. high yield in history," said Harper.

That yield spread might imply creditworthiness issues with emerging world issues, but ELD's lineup hows that problem is likely overstated. Roughly 49 percent of the ETF's holdings are rated AAA, AA or A and another 25 percent are rated BBB.

Of ELD's country holdings, only Brazil looks like a plausible candidate for a ratings downgrade, but even that is something of a stretch and it is not likely the country would be slapped with a junk rating. At least not anytime soon.

Perhaps worst case scenarios that will not come to pass have been priced into emerging markets debt, making ETFs like ELD attractive opportunities at current levels.

"Ultimately, we believe EM local debt is attractively priced at current levels. However, there is always the possibility that market volatility may persist as the U.S. struggles to provide appropriate guidance on the future path of interest rates. At current yields, we believe that EM local debt provides an attractive level of carry that may help dampen future volatility associated with locally denominated fixed income," said Harper.

For more on ETFs, click here.

Disclosure: Author does not own any of the securities mentioned here.

Posted-In: Bonds Short Ideas Emerging Markets Specialty ETFs Emerging Market ETFs Markets Trading Ideas ETFs Best of Benzinga

 

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