[This article originally appeared on our sister site, IndexUniverse.eu.]

Not all that long ago emerging market debt was the preserve of sophisticated investors with a high tolerance for the risks and volatility associated with this asset class. But emerging market debt has moved into the mainstream with the development of bond indices and, in recent months, money has flooded into ETFs that track the most popular indices.

“Year-to-date there has been over US$3 billion invested in iShares’ emerging market debt ETFs. Including funds from other providers, the total inflows to emerging debt so far this year are US$5.2 billion,” said Blanca Koenig, fixed income specialist for BlackRock's ETF business, iShares.

The majority of those US$5.2 billion inflows have been in the U.S. market. U.S.-listed emerging market debt trackers have gained US$3.7 billion in assets this year, while Europe-listed funds have added US$1.5 billion.

Most ETF investors—around 80%—choose funds tracking an index of sovereign debt denominated in foreign currencies, such as JP Morgan’s Emerging Market Bond Index (EMBI). The EMBI includes dollar-denominated debt issued by emerging market sovereigns or quasi-sovereigns.

In Europe, BlackRock also offers access to sovereign emerging market debt denominated in local currencies through an ETF that tracks Barclays Capital’s Emerging Markets Broad Local Currency Bond Index. State Street also offers a European ETF tracking the same index.

Though local currency emerging market debt ETFs lag foreign currency debt trackers in popularity, the assets invested in these two funds are now substantial (iShares’ local currency ETF has US$480 million in assets, while State Street’s has US$385 million).

“These ETFs are a great product. In the past, the only way to access this asset class is through mutual funds, which have higher fees. And mutual funds are designed to be held over the long term, whereas ETFs are more tradeable,” said Peter Tchir, founder of TF Market Advisors and a former investment bank credit trader.

Not only do emerging market debt ETFs make it much easier for investors to access this asset class, but they can also use these products to execute short-term tactical asset allocation strategies, added Tchir.

The popularity of emerging market debt ETFs over this year can, in large part, be attributed to investors turning to other sources of yield as returns on more traditional fixed income asset classes continue to be dismally low.

“For example, the iShares JP Morgan dollar emerging market debt fund has a yield of over 4% at the moment. That’s attractive if you compare it with the yield on US treasuries,” iShares’ Koenig said.

But higher returns usually come with more risks. Many investors can still remember the emerging market debt crisis of 1997/98, when a series of countries suffered major devaluations and defaults. Is there a way for the providers of the emerging market debt ETFs to control these risks?

“Minimising the risk for investors is about choosing the underlying index wisely and running the ETF to ensure that liquidity is well managed,” Koenig said.

JP Morgan’s EMBI is a diversified index with relatively liquid bonds which all settle in the developed markets. There are more operational issues with a local currency index. “That’s why we choose the Barclays index for our local currency ETF because it includes only the most liquid and accessible countries,” said Koenig.

Once the index has been chosen and the fund is running, there has to be some freedom in the way it is run to ensure this can be done efficiently. “We buy the physical bonds of the index but not in exactly the same weight. Our choice depends on the liquidity of the different instruments,” added Koenig.

This approach can increase the tracking error but only slightly. “For example, we only have a forward-looking tracking error of around 10 basis points on the Barclays index ETF product,” said Koenig.

Source and PIMCO have taken a different approach with their EM Advantage Local Bond Index ETF, which has US$12 million in assets.

The PIMCO Source ETF is based on an index that is weighted by the size of a country’s GDP, rather than the size of the debt outstanding. By weighting by GDP, the index’s promoters argue it has higher exposure to those countries with better growth prospects, rather than to those with a higher debt burden.

While concerns over the risk of emerging market debt still linger, the eurozone sovereign debt crisis and the economic slowdown in the US have both caused a profound shift in the perceived risk of emerging market debt.

“Compared to developed world sovereign bonds, it is now much more likely that emerging market sovereigns will keep their promises and not renege on their debt,” said Alan Miller, chief investment officer at SCM Private.

But it’s not only higher returns that are driving investor appetite for these products. There is a growing recognition that many investors’ portfolios have insufficient allocations to emerging market debt, given the better growth prospects for this region.

While most professionals concur about the broad appeal of investing in emerging market debt, whether investors should opt for a dollar-denominated or local currency route is more hotly debated.

Any active emerging market debt fund manager worth their salt will point out not only the higher yield and better economic outlook of the countries they cover, but also the benefits of possible currency appreciation.

“If you look at the purchasing parity of a collection of emerging market currencies, most look undervalued and should strengthen over time,” said Miller.

In addition to the potential returns from currency appreciation, some argue that local currency-denominated debt products have greater liquidity and will therefore provide greater protection for investors in turbulent markets.

“In recent years, there has been a major change in emerging markets. Local currency sovereign debt markets have become deeper and more liquid than those for dollar-denominated debt,” said Anton Dombrovsky, emerging market specialist at PIMCO.

This has been driven by strong demand from global investors, who have noticed that local emerging markets have better potential returns than other parts of the global fixed income market. This, in turn, has persuaded sovereigns to issue more in local currencies than in dollar-denominated instruments, said Dombrovsky.

There is also a strongly growing local institutional base of pension funds and insurance companies, who are investing in local currency sovereign debt.

“This investor base, which is already worth trillions of dollars, will provide a strong technical support in volatile times. They are long-term investors and will continue to hold these instruments, even when overseas investors are selling, because they see local sovereign debt as a risk-free investment,” added Dombrovsky.

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