EM Bonds: Time For Local Currency To Shine?
David Fabian | Feb 03, 2017 12:43AM ET
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 J.P. Morgan USD Emerging Markets Bond ETF (NYSE:EMB) is the largest fund in this space. This ETF 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 the presidential election 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 brings 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 VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (NYSE:EMLC) is the third largest EM bond ETF by asset size with $2.57 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 3-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 last year. This is potentially an interesting dynamic for investors who believe in a resurgence of emerging market currencies to bolster this trade.
Get The News You Want
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.
However, it’s worth bearing in mind 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 (NYSE:LEMB) and WisdomTree Emerging Markets Local Debt Fund (NYSE: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. EM bond funds tend to be heavily influenced by credit 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.
Disclosure: FMD Capital Management, its executives, and/or its clients June hold positions in the ETFs, mutual funds or any investment asset mentioned in this article. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.
Trading in financial instruments and/or cryptocurrencies involves high risks including the risk of losing some, or all, of your investment amount, and may not be suitable for all investors. Prices of cryptocurrencies are extremely volatile and may be affected by external factors such as financial, regulatory or political events. Trading on margin increases the financial risks.
Before deciding to trade in financial instrument or cryptocurrencies you should be fully informed of the risks and costs associated with trading the financial markets, carefully consider your investment objectives, level of experience, and risk appetite, and seek professional advice where needed.
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. The data and prices on the website are not necessarily provided by any market or exchange, but may be provided by market makers, and so prices may not be accurate and may differ from the actual price at any given market, meaning prices are indicative and not appropriate for trading purposes. Fusion Media and any provider of the data contained in this website will not accept liability for any loss or damage as a result of your trading, or your reliance on the information contained within this website.
It is prohibited to use, store, reproduce, display, modify, transmit or distribute the data contained in this website without the explicit prior written permission of Fusion Media and/or the data provider. All intellectual property rights are reserved by the providers and/or the exchange providing the data contained in this website.
Fusion Media may be compensated by the advertisers that appear on the website, based on your interaction with the advertisements or advertisers.