Issues To Consider Before Buying Emerging Market Bonds and ETFs 2

In this series, we’ve looked at several major inputs affecting emerging market bond performance. So what does the overall picture involving sovereign ratings, fund credit quality profile, the financial state of countries, and dollar movement equate to for exchange-traded funds?

As far as sovereign ratings of countries whose bonds are held by ETFs like iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB), VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (EMLC), iShares J.P. Morgan EM Local Currency Bond ETF (LEMB), WisdomTree Emerging Markets Local Debt Fund (ELD), and Vanguard Emerging Markets Government Bond ETF (VWOB) are concerned, one should not be overly worried.

More often than not, rating changes are reflective of past developments which have already been incorporated into asset prices. This becomes even more pronounced for countries such as China, which was downgraded recently, with most of their debt being held locally. Further, as we have seen in the case of Argentina, though the country remains firmly in junk territory, it has made several improvements, earning an upgrade along the way.

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Fund specific parameters

As noted in the previous article, the credit quality profile of EMB has deteriorated over the past two years. That is because the underlying indices of the EMB and others have had to go lower on the credit quality ladder in order to find rewarding investments. This is also represented by the lower spread between US and emerging market corporate bonds in the graph above.

A lower spread means that emerging market issues are offering lower yield than similar maturity US peers. Thus, in order to increase the yield, the underlying indices have been rebalanced to invest in riskier countries and papers.

Investors should also consider another aspect: ETFs are broad-based baskets, even more so when it comes to investing in emerging and frontier markets, as can be seen in the geographic composition of the EMB in the second article of this series. This sharply reduces the exposure that emanates from investing in one geography or region.

Also to be taken under consideration is liquidity. We’ll look at that aspect in a separate series coming shortly. But for now, fund investors need not be overly worried about the credit quality facet, though keeping an eye out for pivotal developments in the top five invested geographies in these funds will be useful in formulating an appropriate exit strategy.

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