Sovereign bonds in the emerging markets asset class have served investors with enviable returns of late. The iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) – the largest US-listed exchange-traded fund investing in the asset class – has returned 6.4% thus far in 2017. Over the past 12 months, the fund has yielded 7% to June 20.
At the same time, stronger emerging market currencies have helped boost local currency emerging market bond funds such as the iShares J.P. Morgan EM Local Currency Bond ETF (LEMB), which has risen 8% in YTD 2017.
Given these rallies and the riskiness attached to investing in emerging market bonds, some market participants are getting jittery about existing portfolio positions. Apart from the seemingly stretched valuations, questions have also emerged on credit quality.
The liquidity aspect
The other metric which is important for investors to keep an eye out for is liquidity.
When referring to market liquidity of any asset class or instrument, we mean the ease with which an investor can transact in a security at minimal cost. The cost aspect not only includes transaction costs levied to go through with the deal, but also the buying or selling level.
Transaction costs are relatively straightforward. For instance, costs levied in order to sell your bond mutual fund on the exchange is one such cost. However, the buying or selling level aspect is a bit more subtle.
It can be explained by assuming that an investor wants to transact on a certain instrument in a certain period of time. However, the market conditions are such that they’re not able to find counter parties at their desired price. If selling, they’re being forced to accept a far lower price than desired and if buying, they’re required to shell out much more money than they’re willing to.
This situation restricts liquidity as the investor in question is either stuck with securities he wants to sell or is unable to buy, thus hampering the free flow of orders.
There are a variety of ways to measure liquidity in financial markets. Let’s look at them in the next article.