Dollar-Dominated Bonds

EMB's and PCY's holdings are dollar-dominated, meaning that the underlying debt holdings are issued in U.S. dollars. This removes a certain level of volatility that changes in currency can cause, while at the same time removing any 'falling-dollar hedge' from the funds.

The pair of emerging markets bond ETFs carry mostly government-issued debt called sovereign debt.

"The JPMorgan Emerging Markets Bond Index contains emerging market sub-sovereign (partially state-owned corporate) bonds as well as sovereign bonds," said Jeffrey Kernagis, the portfolio manager for PCY.

He gave examples for the index's components as: Petronas; The Malaysian Oil & Gas Co.; and PEMEX, the Mexican manufacturing company.

The Deutsche Bank Index for EMB only contains emerging markets sovereign bonds, says Kernagis. "That means the JPMorgan Index (and hence EMB) contains not just country risk but also credit risk," he said.

Most emerging market countries by their definition carry lower credit ratings, and therefore must give higher risk premiums. As of October 31, PCY and EMB had yielded an average coupon of 7.91% and 7.05%, with an average S&P credit rating of BBB and BB, respectively.

The ratings put these investments' average ratings nearly within junk bond categories—PCY being of higher average quality and EMB within the junk bond category. Nevertheless, both ETFs carry many issues of rated junk bond quality. However, since the debt issues are government-issued or government-backed, different factors affect default risk for a country compared to a corporation.

The Awarding-High-Debt Problem

Each underlying index must deal with not overweighting countries and the bonds of that country that have more debt.

According to Kernagis, "Countries with more debt are generally in worse financial shape."

PowerShares' PCY is the less diversified of the two ETFs, with 25 holdings, matching the underlying Deutsche Bank Index. To deal with problems of overweighting riskier higher-leveraged countries, PCY's Deutsche Bank index equal-weights among all countries and all issues within each country, which, says Kernagis, "avoids overweighting countries with greater debt burden."

According to the iShares' EMB fact sheet, the JPMorgan Index methodology is "designed to distribute the weights of each country within the index by limiting the weights of countries with higher debt outstanding and reallocating this excess to countries with lower debt outstanding."

EMB does carry some nonsovereign debt in contrast to PCY's all-sovereign portfolio. EMB holds 40 issues, compared with 117 in the underlying JPMorgan Index.

Though EMB appears more diversified in terms of holdings, the cap-weighted style allows the current situation of holding one Russian Federation bond that makes up over 11% of the fund as its largest holding. But even with the potential for more risk, EMB has clearly served its intended purpose and held its own against its PowerShares peer.

Kyle Waller is a research analyst at Wiser Wealth Management in Marietta, Ga. He is a frequent contributor and columnist for IndexUniverse.com.

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