Emerging Market Bonds are in Vogue, are Emerging Stocks Next?

foreign world marketsFrom David Fabian: Negative interest rates in several major developed foreign nations may be the biggest theme driving the search for yield in 2016. Many investors have navigated their way to U.S. Treasury, investment grade corporate, and municipal bonds for safety.  However, if you want an above average yield and are willing to take on more credit risk, emerging market bonds have become a preferred landing spot.

According to fund flow data from ETF.com, the top three emerging market bond ETFs for net inflows year-to-date include:

  • iShares JP Morgan USD Emerging Markets Bond ETF (EMB) + $3 billion
  • VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (EMLC) + $566 million
  • Powershares Emerging Markets Sovereign Debt Portfolio (PCY) + $493 million

The growth in overall assets for EMB stands out in particular.  This fund started the year as the largest emerging market bond offering and has seen its asset size grow by more than 50% in 2016 to $8.5 billion.

EMB tracks a passively managed index of U.S.-dollar denominated sovereign bonds of more than 30 emerging market nations.  The total number of securities in this diversified ETF is currently well over 300.  Top country weightings within EMB include: Mexico, Indonesia, Russia, and Turkey.  This fund sports a 30-day SEC yield of 4.35%, has an effective duration of 7.22 years, and charges a net expense ratio of 0.40%.

So far this year, EMB has risen more than 12% and just recently hit new all-time highs in July.  The combination of gathering momentum in emerging market stocks as well as favorable currency trends may also be helping to support this rally in sovereign debt.  Political upheaval in Turkey, Brazil, and other contentious nations have failed to offer meaningful resistance as well.

It should also be noted that EMB has outperformed domestic high yield favorites such as the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) this year.  HYG has gained 9.55% on a year-to-date basis and offers a modestly higher SEC yield of 5.65%.  The sharp price appreciation of EMB is directly correlated with its lower relative yield.

Another notable success story in the emerging market category is the resurgence in local currency bonds.  Similar to currency-hedged ETFs, these local currency bond funds allow investors the flexibility to tailor their exposure to capitalize on both credit/interest rate trends as well as foreign exchange momentum.

EMLC has total assets of $1.8 billion and tracks an index of 220 government fixed-income securities.  The fund has an effective duration of 5.00 years, a 30-day SEC yield of 5.55%, and a net expense ratio of 0.47%.  Brazil, Poland, Mexico, and Malaysia make up the top country allocations.

 

 

Funds like EMLC have been in a notable downtrend since peaking in 2013 as currency headwinds persisted.  Nevertheless, this ETF is admirably pacing its U.S. dollar-denominated peers this year and recently set a fresh recovery high.  The overweight positioning in Brazil, also a top performing 2016 stock market, has likely benefitted this index.

The Bottom Line

Emerging market bond funds have often experienced periods of outperformance during rallies in global stocks and credit-sensitive asset classes.  Nevertheless, the bloom of fresh capital to this sector speaks volumes about the search for yield at this juncture.  Furthermore, the chase in assets towards a top performing area of the market in any given year is a reoccurring behavioral theme.

Investors considering this arena should note that the higher associated yield also carries a greater risk of price volatility as well.  Funds like EMB or EMLC may be appropriate to overweight your portfolio towards foreign exposure or as a tactical component of a diversified fixed-income strategy.

The iShares MSCI Emerging Markets Index ETF (NYSE:EEM) rose $0.19 (+0.53%) to $35.80 in Tuesday afternoon trading.

This article brought to you courtesy of FMD Capital.

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