A Closer Look At Emerging Markets Bond ETFs

At the end of last year, two new exchange-traded funds became available in the U.S., providing investors the opportunity to include emerging markets bond funds into their portfolios for the first time.

Now as they approach their first full year of operations, what exactly have the PowerShares Emerging Markets Sovereign Debt Portfolio (NYSE: PCY) and the iShares JPMorgan USD Emerging Markets Bond Fund (NYSE: EMB) brought to ETF investing?

For one, these two funds provide inexpensive access to markets previously difficult or costly to invest in. But clearly the other major appeal of PCY and EMB is that both offer low correlations to U.S. markets over longer periods and the potential of equitylike returns.

Below is the yearly correlations of both ETFs' underlying benchmarks using monthly price data. The graph shows low correlations between the S&P 500 and these indexes over a longer period, which indicates that emerging markets debt ETFs can provide significant risk reduction to U.S. investors.

As the graph indicates, the indexes which PCY and EMB track have a low long-term correlation to the S&P 500, (0.57 and 0.59, respectively), over the time period graphed. So far in 2008, by historical standards, we've seen a highly correlated year between emerging market bonds and the S&P 500's returns.

At first glance, the performance this year of both ETFs might seem disappointingly poor. But consider the global credit problems and the pullout from emerging capital markets and the picture comes into better focus.

Year-to-date heading through October, PCY was down 35.02% and EMB had fallen 24.11%, according to Bloomberg data.

During times when defaults seem to be looming, major sell-offs can be expected, especially from commodity-based countries like Russia, Brazil and Venezuela. This year has been a unique period when all credit markets have seen investors running from high-yielding and high-risk debt portfolios. This combined with massive sell-offs from emerging markets in general have created a situation very unfavorable for emerging markets bond investors.

In fact, The Economist reported that as of October 29, the International Monetary Fund (IMF) has approved a new "short-term liquidity facility." This new facility will provide three-month loans to emerging economies and promises loans in a timely manner.

According to the magazine, the IMF will have less stringent conditions for the loans and a guarantee of quick responses to the loan request. The loan has many other functions that should provide emerging countries with the liquidity they may need in an extremely timely manner. This new plan should ease default fears among investors in sovereign debt issues and should have a direct impact on easing the default and credit risk of emerging market debt portfolios during this current economic climate.

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.

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.