Emerging market bond ETFs well positioned to withstand global downturn

Dec 28th, 2011 | By | Category: Fixed Income

Income-seeking investors have been piling in to all sorts of high-income funds over the past few years, but one asset class that hasn’t received much attention is emerging market government bonds.

Emerging market bond ETFs well positioned to withstand global downturn

As economies like China continue to boom, emerging market bond ETFs are well positioned to withstand a global downturn.

The argument for investing in emerging market government bonds is broadly the same as that made for investing in emerging market equities. In essence, emerging market economies are growing far more quickly than those of developed countries, underpinned by healthy fundamentals, including low levels of debt, rapid population growth, increasing domestic demand, industrialisation, economic reform, and improving governance.

With these strong fundamentals, sovereign bonds of emerging market nations may be better positioned to withstand a global downturn, while at the same time offering investors the opportunity to generate strong returns without the level of volatility seen with equities. Moreover, as these nations grow in wealth, their currencies should appreciate, leading to gains for sterling investors.

Furthermore, with investors scrambling for cover as the eurozone crisis threatens to boil over, investors should note that a deeper, more systemic crisis would likely not change the underlying secular story in favour of emerging markets. That said, the road will almost certainly be bumpy and the key is for investors to remain focused on the long-term case.

The interest rate outlook is also generally more favourable for emerging markets with some countries (i.e. those with relatively high real interest rates) having room to cut policy rates. Of these, Brazil’s central bank has already started to move aggressively, cutting its policy rate by 150 basis points to 11.0% since August 2011. Brazil has signalled it will continue its monetary policy easing cycle if growth weakens further.

South Africa and Mexico may also have room to cut policy rates given strong relative credit fundamentals, a comparatively subdued inflation outlook and a generally high sensitivity to the global economic outlook due to their export-driven economies. This bodes well for bonds in these countries as lower interest rates translate into lower yields, which, in turn, means rising bonds prices (all else held constant).

Emerging markets issue debt primarily in either their own local currency or in dollars. Surprisingly, many investors continue to focus purely on dollar-denominated bonds, overlooking the opportunities in local currency markets. And yet most analysts agree that emerging market currencies such as China’s renminbi and Brazil’s real will ultimately appreciate over the long term. As well as return opportunities (via yield and currency appreciation), local-currency bonds can provide added portfolio diversification including a natural hedge against home currency weakness.

Of course, there are significant risks to investing in emerging market bonds. Risks range from market infrastructure issues such as a lack of transparency, poor governance and illiquidity, to more obvious concerns such volatility, currency fluctuations, political upheaval and, of course, inflation.

Despite the risks, however, an allocation to emerging market government bonds should at least be considered for most wealth generation strategies.

Investing directly into emerging market bonds can be complicated. Fortunately, there are a number of London-listed emerging market sovereign bond ETFs to choose from.

Emerging market government bond ETFs:

PIMCO EM Advantage Local Bond Index Source ETF
Physically replicated. Local currency debt. Tracks the PIMCO Emerging Markets Advantage Local Currency Bond Index. The PIMCO Emerging Markets Advantage Local Currency Bond Index is a GDP-weighted index that offers diversified exposure to emerging market government local currency debt that is representative of the countries driving emerging markets growth.

iShares Barclays Capital Emerging Market Local Govt Bond ETF
Physically-replicated. Local currency debt. Tracks the performance of the Barclays Capital Emerging Markets Local Currency Core Government Index. The Barclays Capital Emerging Markets Local Currency Core Government Index offers exposure to emerging markets government debt from eight countries in local currency.

iShares JPMorgan $ Emerging Markets Bond ETF
Physically-replicated. Dollar denominated debt. Tracks the performance of the JP Morgan Emerging Markets Bond Index Global Core Index as closely as possible. The JP Morgan Emerging Markets Bond Index Global Core Index offers exposure to US dollar-denominated sovereign and quasi-sovereign bonds from emerging markets countries.

DB X-trackers Emerging Markets Liquid Eurobond Index ETF
Swap-based. Eurobond debt (i.e. EUR, GBP, USD, CAD or JPY denominated). Tracks the Deutsche Bank Emerging Markets Liquid Eurobond Euro Index. The Deutsche Bank Emerging Markets Liquid Eurobond Euro Index is intended to reflect the composite total return performance of emerging market sovereign and quasi-sovereign debt instruments.

Lyxor iBoxx $ Liquid Emerging Markets Sovereigns ETF
Swap-based. Dollar denominated debt. Tracks the Markit iBoxx USD Liquid Emerging Markets Sovereigns Index. The Markit iBoxx USD Emerging Markets Sovereigns index contains bonds denominated in USD and issued by the low or middle-income sovereign states, as defined by the World Bank.

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