The Case for Emerging Market Bon ETFs

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Depending on the investor´s risk appetite and investment horizon, among other things, bonds can be an important part of diverse portfolios and investment strategies. Unfortunately, the current scenario of historically low interest rates makes bond investing a difficult task, in which the risk and return trade off doesn't look very convenient from a long term perspective. Emerging market bond ETFs could be a smart alternative to internationally diversify your bond exposure in the search for better returns.

The Rationale for Emerging Markets Bonds

The world has changed drastically in the last decade; emerging markets have surged as a compelling investment destination, offering stronger economic fundamentals and higher interest rates than developed countries. In terms of fiscal budget, most emerging nations are in a much better shape than the US, Europe, or Japan, and they are not embarked in the same kind of ultra low interest rates policies applied in most developed countries.

In general, emerging markets have lower debt levels than developed ones. Their credit ratings have been improving over the last years, but there is still room for further upside if these countries continue on the right path of economic growth and fiscal responsibility. While interest rates in the US are at rock bottom levels, central banks in emerging markets can still continue reducing rates and delivering capital gains for holders of emerging market debt.

Emerging Markets US Dollar Bond ETFs

iShares JPMorgan USD Emerging Markets Bond (NYSEMKT: EMB) invests in debt instruments from countries like Brazil, Russia, Mexico, Turkey, Indonesia, and the Philippines. This ETF includes only US Dollar bonds, so it eliminates currency risk for US investors.  The instrument has dividend yield of 4.3% for the last year and an annual expense ratio of 0.6%.

PowerShares Emerging Mkts Sovereign Debt (NYSEMKT: PCY) replicates the same index as EMB for a lower expense ratio of 0.5% annually. PCY has a smaller asset base of $2.81 billion, versus $6.19 billion for EMB, but still enough liquidity for most investors. PCY follows an equal weighted methodology for its portfolio construction; this means a higher proportion of smaller countries like Pakistan, Peru, Qatar, Lithuania, and Colombia. Also, PCY has a marginally higher 12 month yield than EMB at 4.73%.

Comparing yields is not as easy with bond ETFs as it is with individual bond securities, but the SEC yield – a standardized yield calculation – shows that emerging market bond ETFs have a considerable advantage over their US counterparts. While EMB and PCY have SEC yields of 3.35% and 4.03%, respectively, iShares Barclays 7-10 Year Treasury Bond Fund (NYSEMKT: IEF) -  which invests in US treasuries of similar maturities - has a much lower SEC yield of 1.32%.

 Local Currency Exposure

Other ETFs offer the possibility to invest in emerging market bonds while maintaining exposure to their local currencies. This can be an added source of volatility, because emerging market currencies usually fall versus the US dollar in times of economic uncertainty.

But at the same time, local currency instruments offer higher yields, and investing in emerging markets currencies doesn´t sound like a bad idea at all. If these counties have better economic fundamentals and their monetary policies are more conservative, their currencies should increase in value versus the US dollar over time, regardless of short term volatility.

Emerging Markets Local Currency Bond (NYSEMKT: EMLC) invests in local currency bonds from Brazil, Malaysia, Mexico, Poland, South Africa, and Thailand, among others.  Most of the bonds in the portfolio – around 80% of them – are investment grade rated.  The ETF has a SEC yield of 5.7% and an expense ratio of 0.47%, while assets under management are near $927 million.

Another possibility for local currency emerging markets debt is WisdomTree Emerging Markets Local Debt Fund (NYSEMKT: ELD), which follows an active strategy instead of replicating an index like most ETFs do. ELD has a similar geographic exposure to the one offered by other emerging markets debt instruments, but a lower maturity currently in the area of 4.5 years versus 7.5 years for other instruments. This ETF has a SEC yield of 3.96%, an expense ratio of 0.55%, and assets under management of $1.38 billion.

Bottom Line

Emerging market debt is usually considered riskier than US bonds, and it’s certainly more volatile. On the other hand, when you compare yields and economic fundamentals, emerging markets bonds look better positioned than their US counterparts in terms of risk and return potential. As if that weren´t enough, diversification is another reason to consider adding some emerging markets exposure to a fixed income portfolio.

acardenal has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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