Corporate Bond ETFs: An Alternative to EM Sovereigns

Investors embraced emerging markets sovereign debt, both the dollar-denominated and local currency varietals, in significant fashion last year.

Returns generated by and inflows to the ETFs tracking this asset class affirm that assertion.

Due to higher yields than what is available on U.S. Treasuries and other developed market bonds and, in many cases, stronger government balance sheets, emerging markets sovereign debt has attracted an increasingly large following among developed market investors. However, there is an alternative that should not be ignored.

That being emerging markets corporate debt. Previously inaccessible via ETFs, developing world corporates made a splash on the ETF scene last year when the WisdomTree Emerging Markets Corporate Bond Fund (NASDAQ:EMCB) debuted in March.

Those that thought emerging markets corporates would be too much of niche play for most investors have had to eat their words. EMCB had $88 million in assets under management in late October. That number now resides at $126.6 million. Translation: EMCB' AUM total has surged almost 44 percent in five months.

So successful has EMCB been that it prompted the creation of not one, but two copycat funds, the iShares Emerging Markets Corporate Bond Fund (NYSE:CEMB) and the SPDR BofA Merrill Lynch Emerging Markets Corporate Bond ETF (NYSE:EMCD). Proliferation and success of ETFs are not the only reasons investors should consider developing world corporates.

"Due to growth in new issuance, the investable universe of emerging market (EM) corporate debt is now larger than the market for EM U.S. dollar (USD) sovereigns," said WisdomTree Portfolio Manager Rick Harper in a new research note. "On average, EM corporate bonds currently feature higher credit quality, less sensitivity to changes in U.S. interest rates, and offer greater incremental income potential than EM USD sovereigns."

Harper's observations jibe with comments made by PIMCO in late October.

In a note written by PIMCO's Ignacio Sosa and Anton Dombrovsky, the bond house said "the dollar-denominated EM corporate market has been growing steadily, and many corporates can offer higher yields and lower durations than sovereigns."

As of the end of January, the J.P. Morgan EMBI Global EM USD Sovereigns universe had a market size of just under $572 billion compared to a market size of nearly $624.5 billion for the J.P. Morgan CEMBI Broad EM Corporates realm, according to WisdomTree data.

The data confirm Harpers comments about superior credit quality and less sensitivity to U.S. interest rate fluctuations. Over 73 percent of the aforementioned emerging markets corporate bond gauge is rated investment-graded compared to less than 62 percent for the sovereign debt index.

Average duration for the corporates is 5.59 years compared to 7.5 years for the sovereigns. Duration measures a bond's sensitivity to interest rate changes.

Evidence has started to mount that EM corporates represent a valid alternative or complement to sovereign debt.

"We believe that the factors that led to EM USD sovereign outperformance may be waning," said Harper. "In our view, EM corporate bonds offer the next wave of opportunities in EM fixed income. For example, in Russia, investing in corporate bonds as opposed to government debt resulted in a 1.64% increase in yield, with less interest rate risk as of February 15, 2013."

With an allocation of 20.99 percent, Russia is EMCB's second-largest country weight behind Brazil. Mexico, Hong Kong and Colombia round out the top-five country weights in the ETF. EMCB also features exposure to Jamaica, Kazakhstan and Venezuela, among others, and that may have investors pondering if they will be adequately compensated for the perceived added risk.

"In an investment environment where investors are constantly questioning whether they are being adequately compensated for the amount of credit risk they are assuming, they are simultaneously confronting the prospect of higher long-term interest rates," Harper said. "We believe EM corporate debt could provide an attractive solution to this dilemma. By enhancing yield potential and overall credit quality, while at the same time reducing interest rate risk, EM corporate bonds could provide attractive total returns compared to EM USD sovereign debt in 2013."

Indeed, EM corporates do feature attractive yields. The average yield to maturity on investment-grade bonds in J.P. CEMBI Broad EM Corporates Index is 36 basis points higher than the highly-rated issues in the sovereigns index. For the junk issues, the yield-to-maturity difference is 39 basis points in favor of corporates, though corporates often feature better yields than government debt.

A more relevant comparison is EMCB to the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSE:LQD), the largest corporate bond ETF by assets. EMCB has a 30-day 3.78 percent compared to 2.9 percent for LQD. EMCB's effective duration is 6.17 years compared to 7.69 years for LQD.