Emerging market bond ETFs well placed to manage fallout from US fiscal cliff

Dec 11th, 2012 | By | Category: Fixed Income

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As the US teeters on the so-called “fiscal cliff” combination of tax hikes and government spending cuts, investors are increasingly looking for assets which are well placed to cope with the potential fallout.

Emerging market bond ETFs well placed to manage fallout from US fiscal cliff

Dependence on exports to the US has generally been declining in Asia and emerging market countries over the past decade.

While the effect will be felt around the world and in almost all asset classes, the impact on emerging markets fixed income may not be as severe as some might expect, according to Fran Rodilosso, portfolio manager at Market Vectors, a leading provider of exchange-traded funds (ETFs).

“EM local currency bonds are becoming more strategic, as opposed to purely tactical, allocations for many investors. We believe the market is supported by – in addition to the underlying fundamentals – improved liquidity, expanded yield curves, and a greater opportunity to diversify,” says Rodilosso.

Rodilosso cautions that while EM debt holdings have become more strategic, not all the “hot” tactical money has vanished from the market. “We witnessed underperformance on EM local debt in 2011, due in part to outflows on a flight-to-quality trade, so that type of hot money is indeed still there,” he says. “But the progression towards more permanent allocations and, ultimately, lower volatility still appear to be in place.”

FEATURED PRODUCT

Pimco EM Advantage Local Bond Index Source ETF
(LON:EMLB)

– Managed by bond experts Pimco, the fund provides
exposure to a diversified portfolio of emerging
markets local currency government debt

– The fund’s GDP-weighted approach enhances
exposure to China and India and emphasises
growing economies, unlike market-cap strategies,
which overweight more heavily indebted countries

– Physically backed with full transparency to
underlying holdings

– UCITS III compliant, London listed, UK Reporting
Status, eligible for ISAs and SIPPs, TER 0.60%,
registered for distribution across much of EU

Should the US fiscal cliff talks fail, Rodilosso expects that the initial short-term reaction of emerging market local currency bonds will be negative, as investors pull back from “risky” assets. And more broadly, a significant drop in US growth would likely dent most EM country fundamentals, as well.

However, the relative strength of emerging market economies and the superior health of their balance sheets should remain intact. Furthermore, dependence on the US has declined as emerging market countries have diversified their export bases.

Mark Mobius, a widely respected expert on emerging markets, recently noted that: “Dependence on exports to the US has generally been declining in Asia and the emerging countries over the past decade. The absolute dollar figures for total exports have been rising, but emerging market countries have been diversifying their export base to include countries beyond the US and Europe.”

A demonstration of this is that the largest destination for exports from Japan, Korea, the Philippines, Vietnam, Thailand, Malaysia, Singapore and Indonesia is not the US, as many might once have presumed, but China. China itself is also less dependent on the US, too. According to Mobius, “China’s economy is so large that its exports to the US represent only 5% of its GDP.”

The bottom line from an investment standpoint is that while the fiscal cliff will have negative implications for many asset classes, including those of emerging markets, the impact on emerging markets fixed income is likely to be manageable due to a combination of superior fundamentals and reduced export dependency. Take into account also the yield advantage offered by emerging market debt over comparable developed market equivalents and the asset class remains highly attractive, despite the dangers of the fiscal cliff.

Looking past the current drama with the fiscal cliff, Market Vectors’ Rodilosso forecasts growing appetite among institutional investors for EM local currency bonds in general.

In particular, he sees more interest in the ‘dim sum’ bond market – where investors can gain more yuan exposure, typically through investments in investment grade corporate borrowers from within and without China. “The consensus seems to be forming that further yuan appreciation over the medium term can amplify higher rates that most of these entities will pay via US dollar- or euro-denominated issues.”

Market Vectors offers a number of NYSE Arca-listed ETFs in this space including the Market Vectors Emerging Markets Local Currency Bond ETF (EMLC), which recently surpassed $1 billion in assets, and the Market Vectors Renminbi Bond ETF (CHLC).

UK investors looking to access local currency emerging market bonds have a number of ETFs to consider, including funds from Pimco/Source, BlackRock’s iShares and SSgA’s SPDR:

Pimco EM Advantage Local Bond Index Source ETF (EMLB)
This physically-backed fund, managed by Pimco and launched in collaboration with European ETF specialist Source, offers high quality diversified exposure to countries driving emerging markets growth. Unlike traditional market-capitalisation-weighted indices, which reflect past patterns of debt issuance, the fund’s underlying index is weighted by GDP. This accentuates exposure to China and India and emphasises growing economies with strong fundamentals where there may be new opportunities. London Stock Exchange. TER 0.60%.

iShares Barclays Capital Emerging Market Local Govt Bond ETF (SEML)
Physically backed, the fund tracks the Barclays Capital Emerging Markets Local Currency Core Government Index. The index offers exposure to emerging markets government debt from eight countries in local currency; Mexico, Poland and South Africa form the largest weights, comprising a combined 52%. The index includes certain maturity and minimum issuance size provisions to ensure liquidity. London Stock Exchange. TER 0.50%.

SPDR Barclays Capital Emerging Markets Local Bond ETF (EMDL)
Physically backed, the fund tracks the Barclays Capital Emerging Markets Local Currency Liquid Government Index, a country-constrained index designed to provide a broad measure of the performance of liquid local currency emerging markets debt. The index limits country exposure to a maximum of 10% and, to be included, securities must have an amount outstanding of at least $1 billion equivalent. The country cap increases diversification. The top three weights are Brazil, South Korea and Mexico, which together comprise 30%. London Stock Exchange. TER 0.55%.

For investors specially looking to target Asia, the SPDR Citi Asia Local Government Bond ETF (ABND) and iShares Barclays EM Asia Local Govt Capped Bond ETF (SGEA), both listed on the London Stock Exchange, offer dedicated exposure to this fast-growing and fundamentally strong region.

(The funds mentioned have been registered or passported for distribution in a number of other European/EU countries. The SPDR funds also have European exchange cross-listings.)

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