Emerging Markets Looking Good, Maybe Better Than the U.S.

Bonds have regained their momentum this year, but after a multi-year run, many traditional fixed-income assets look pricey or overvalued. Alternatively, investors may consider opportunities in exchange traded funds that track emerging market debt.

Investors may be attracted to the cheaper valuations and wider yield premiums that emerging market bonds offer over safe-haven government debt, especially with yields on benchmark 10-year Treasuries dipping back toward historical lows this year.

Moreover, emerging market assets as a whole remain depressed to developed markets. Consequently, the unloved area may have already priced in most of the negatives that have previously pressured the market.

While many emerging markets have a bad reputation for spiraling debt defaults in face of rapid currency depreciation, the developing economies are more resilient than many would expect. The developing economies are typically associated with greater risks, but many emerging countries hold investment-grade debt ratings through sound financial management.

Additionally, emerging market governments have accumulated less dollar debt than the spendthrift U.S., built up their foreign reserves and adopted flexible exchange rates to obviate mistakes made during the 1980s and 1990s crisis.

The emerging market bond asset category also provides a good diversifer for traditional bond and stock investment portfolios. Emerging market debt has exhibited low correlations to both U.S. equities, Treasuries and corporate debt.

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The attractive emerging debt yields, though, are not without their risks. Many fixed-income observers are closely watching the Federal Reserve’s monetary policy.

A Fed rate hike could cause a large exit out of emerging market assets in favor of safer returns in the U.S. Fixed-income investors can diversify into emerging market through a number of ETF options. For instance, the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSE:EMB) and PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEA:PCY) provide exposure to U.S. dollar-denominated emerging debt securities, or developing country bonds issued in U.S. dollars. The USD denomination can help support these funds in case of a sudden appreciation in the greenback.

EMB, the largest and most liquid emerging market bond ETF, tracks the J.P. Morgan EMBI Global Core Index, a market-cap-weighted index. Potential investors should note that since it is a cap-weighted index, countries with greater debt will have a larger position in the portfolio. The ETF, though, employs country constraints to ensure diversification and moderate exposure to heavily indebted countries.

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Top country weights include Mexico 6.9%, Russia 5.4%, Indonesia 5.3%, Turkey 5.1% and Philippines 5.1%. Investors may also be surprised to find that the majority of credit issued is investment-grade, including AA 2.2%, A 12.4% and BBB 42.2%, along with some speculative-grade BB 19.2%, B 16.1%, CCC 5.3% and D 2.6%. EMB has a 7.1 year duration and a 4.98% 30-day SEC yield.

Alternative to EMB's cap-weighted indexing methodology, PCY tracks the DB Emerging Market USD Liquid Balanced Index, which equally weights bonds so that each country has an equal weighting. Top country weights include Brazil 3.6%, Colombia 3.6%, Indonesia 3.6%, Mexico 3.5% and Peru 3.4%. Credit quality includes AA 6%, A 10%, BBB 37%, B 17% and CCC 3%. The ETF has a 8.43 year duration and a 5.39% 30-day SEC yield.

With many emerging market central banks cutting interest rates amid lower inflation, the loose monetary policies should help support many local rates markets. Consequently, investors may also take a look at local currency-denominated ETFs, or emerging market bond ETFs that are issued in their local currencies, including the VanEck Vectors Emerging Markets Local Currency Bond ETF (NYSE:EMLC) and actively managed WisdomTree Emerging Markets Local Debt Fund (NYSE:ELD). EMCL, which tracks the J.P. Morgan GBI-EMG Core Index, tracks local bond markets in emerging economies, including Poland 9.2%, Mexico 8.9%, Brazil 8.4%, Malaysia 8.2% and Indonesia, among others. Credit quality is also higher, with AAA 6.6%, AA 3.1%, A 29.7%, BBB 32.3% and BB 16.3%. The ETF comes with a 4.83 year duration and a 5.85% 30-day SEC yield.

ELD is an actively managed ETF that focuses on local debt denominated in currencies of emerging market countries, including Brazil 12.0%, Poland 9.9%, Mexico 9.8%, Russia 7.3% and Colombia 7.0%. Credit breakdown includes AAA 5.7%, AA 12.6%, A 39.9%, 40.6% BBB and 0.5% B. The actively managed component may also help the ETF more quickly adapt to changes in central bank policies or currency fluctuations. ELD has a 4.84 duration and a 5.75% 30-day SEC yield.

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