Market Overview

A Bond ETF For Commodities Upside

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A Bond ETF For Commodities Upside
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Bonds and commodities are rarely joined at the hip, but when it comes to emerging markets debt, commodities can be an important determinant of returns. Some exchange traded funds confirm that rising commodities benefit emerging markets bonds.

Over the past 12 months, the S&P GSCI Commodity Index is up 7.5 percent, while the VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (NYSE: EMLC) is higher by 13.2 percent over that period. EMLC's positive correlation to commodities prices is not surprising. The ETF holds bonds denominated in local currencies, meaning it benefits from a weaker U.S. dollar — as do commodities.

“Commodity prices have been on a steady upswing since early 2016, rising over 40 percent through Jan. 31, 2018,” VanEck said in a recent note. “Many investors, assuming a tight link between commodity prices and emerging market local currency returns, fairly view broad emerging markets exposure as a way to play the recovery in commodities.”

EMLC Commodities Exposure

EMLC has a 30-day SEC yield of 5.72 percent, which is well above what investors receive on 10-year Treasuries or the MSCI Emerging Markets Index. The ETF holds 289 bonds, plenty of which hail from developing markets that are major commodities producers.

Brazil, Mexico, Indonesia and South Africa, all of which are major producers of various commodities, are four of EMLC's top five country exposures. That quartet combines for nearly 36 percent of the ETF's geographic weight. Overall, EMLC features exposure to 20 countries, more than half of which can be considered large commodities producers.

“The overall moderate correlation of index returns with oil prices reflects the diversity of economies within the index,” said VanEck. “Despite rising commodity prices since 2016, the majority of emerging markets local currency bond returns over the past five years have been driven by local interest rates rather than currency appreciation.”

Risks

In addition to a sudden reversal in commodities prices, the primary potential risks facing ETFs like EMLC are interest rate and credit risk. In the case of rate risk, no emerging markets aside from Mexico are expected to hike rates this year, so rate risk is mostly off the table for EMLC.

Over half of EMLC's holdings carry junk ratings, so there is some credit risk, though that has been somewhat mitigated by the recent Standard & Poor's upgrade of Russia to investment-grade territory. Russian bonds account for 5.3 percent of EMLC's roster.

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