Emerging market bonds were one of the few bright spots across the fixed-income landscape in 2016. This category trailed only U.S. high-yield debt by total return metrics despite some meaningful volatility in the aftermath of the U.S. election. Investors also took notice of this outperformance and the favorable yields to boot.
The iShares JPMorgan USD Emerging Markets Bond ETF (NYSEARCA:EMB) is the largest fund in this space. This exchange-traded fund owns nearly 350 U.S. dollar-denominated securities of over 30 emerging market nations. Top country allocations include: Mexico, Indonesia, Russia and Turkey.
One of the more attractive features of EMB is its hefty 30-day SEC yield, which is currently hovering near 5%. This income stream is comparable to the current yield on a diversified index of U.S. high-yield bonds, which is why these two categories are often evaluated on similar merits.
EMB posted a total return of 9.41% in 2016 and continues to demonstrate a meaningful recovery pattern since Election Day on the chart below. The combination of above-average yield and price performance allowed this fund to add more than $3.2 billion of fresh capital last year. This bring its total asset base north of $8 billion.
The friction of U.S. interest rates and the volatility in the U.S. dollar weren’t enough to derail the surge in EM bonds for 2016. Furthermore, we saw a significant resurgence in local currency denominated debt as well.
The Market Vectors Emerging Mkts Local ETF (NYSEARCA:EMLC) is the third largest emerging market bond ETF by asset size with $2.6 billion under management. This fund took in more than $1 billion in new capital last year as well. Local currency bonds are priced in the same denomination as the host country, which gives investors a new dynamic to consider with respect to foreign exchange markets.
Here is a great independent primer on how local currency EM bond funds work.
On a three-year chart, EMLC began to underperform its EMB counterpart in the later stages of 2014 and has just begun to show signs of recovery over the past year. This is potentially an interesting dynamic for investors who believe in a resurgence of emerging market currencies to bolster this trade.
Some may look at the EMB/EMLC comparison and think to themselves that there is an opportunity for value arbitrage in there. They may be right, even though EMLC owns a slightly different mix of underlying sovereign bonds and country exposures than EMB.
It’s worth bearing in mind, however, that the real arbitrage is on the currency side rather than the bonds themselves. A weakening of the U.S. dollar versus the Brazilian real, Mexican peso and Polish zloty would be a significant driver of future performance in this fund. These factors should all be considered before taking the plunge in the emerging market bond space.
Two other potential alternatives are the iShares Emerging Markets Local Currency Bond ETF (NYSEARCA:LEMB) and WisdomTree Emerging Markets Local Debt Fund (NYSEARCA:ELD). LEMB is another passively managed index with differentiated country exposure, while ELD takes an active approach to its security selection and diversification.
The Bottom Line
With many choices to consider, income investors should be on the lookout for potential opportunities in the local currency segment. There will ultimately come a time when these funds outshine their conventional U.S. dollar peers.
There are also several risk factors that must be considered as well. Emerging market bond funds tend to be heavily influenced by global credit conditions and many of the underlying countries are driven by natural resource-based economies. This makes the trends in commodity prices an aspect that may influence sovereign bond prices and must be on your radar.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. Learn More: Why I love ETFs, And You Should Too.