EM Bond ETFs Getting Better...Sort of

One of this year's most downtrodden and vilified asset classes is emerging markets bonds. High-yield or investment-grade. Dollar-denominated or local currency issues.

It does not matter. Practically all of the ETFs that offer investors exposure to these bonds have been repudiated due to, among other factors, plunging currencies and fears about an end to the Federal Reserve's quantitative easing program.

Heading into the start of trading Wednesday, the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSE:EMB) was down 8.3 percent for the year while the Market Vectors Emerging Markets Local Currency Bond ETF (NYSE:EMLC) was off 10.4 percent. Nearly $1.9 billion has been pulled from EMB, which tracks nearly 200 dollar-denominated holdings that are mostly rated investment-grade.

Things may be starting to change for those ETFs and others like them. Maybe, just maybe and yes, there should be emphasis on "maybe," but over the past month, some emerging markets bond ETFs have at least been less bad than some supposedly safer bond funds. For example, since June 17, EMB, EMLC and the WisdomTree Asia Local Debt ETF (NYSE:ALD) are off an average of 2.7 percent. A loss is a loss, but all three of those ETFs have done better in the past 30 days than the iShares 20+ Year Treasury Bond ETF (NYSE:TLT).

ALD has only been slightly worse over that time than the more famous, supposedly less risky PIMCO Total Return ETF (NYSE:BOND).

Almost Positive Signs There are some signs, perhaps faint, that all is not lost for emerging markets bond ETFs. For starters, a rising interest rate environment in the U.S. could boost the allure developing world debt. U.S. Treasurys are rate sensitive, but emerging markets sovereigns are credit sensitive because investors are concerned about repeats of such ominous events as the Asian financial crisis and Russian ruble collapse of the late 1990s.

Actually, emerging markets bonds prove usually prove durable during periods of rising U.S. rates. The average return for these bonds in rising rate quarters dating back to 1993 is 2.33 percent, making developing world debt the third-best performing bond niche when U.S. rates rise behind only convertibles and U.S. corporate junk, according to Morgan Stanley Wealth Management.

Clearly, no one in their right mind would say emerging markets bonds, currencies or equities have been good places to invest this year. The returns clearly state the opposite is true, but widening spreads for some of these debt ETFs relative to U.S. Treasurys imply dark views of issuer creditworthiness. EMB's trailing 12-month yield is now about 210 basis points north of 10-year Treasurys. The PowerShares Emerging Markets Sovereign Debt Portfolio (NYSE:PCY), another dollar-denominated fund, is almost 240 basis points ahead of 10-year Treasurys.

Only the WisdomTree Asia Local Debt Fund, which it should be noted is not an all emerging markets ETF, but one with sturdy credit quality features a distribution yield that is not well above 10-years.

These wide spreads are present despite the fact that at the end of 2012, the average fiscal deficit across the emerging market space was less than 2%, with no region averaging a deficit worse than 3% of GDP, according to iShares Global Chief Investment Strategist Russ Koesterich.

Supporters There is no doubt emerging markets bond ETFs are beaten up. In a group comprised of EMB, EMLC, PCY and the WisdomTree Emerging Markets Local Debt Fund (NYSE:ELD), ELD is the best year-to-date performer with a loss of 8.1 percent. That has not stopped some professional investors from recently taking nibbles at emerging markets bonds.

Jeff Gundlach, CEO of investment manager DoubleLine, recently said he sees some opportunities with dollar-denominated emerging debt.

Goldman Sachs Asset Management has been increasing holdings on short-dated, local-currency bonds sold by Brazil and 30-year, local-currency bonds sold by Mexico, according to the Wall Street Journal.

Brazil has been on something of a scorched-earth, rate-rising campaign this year as a means of combating inflation, but Mexican debt has long been an emerging world favorite among some noteworthy bond investors. Investors looking to gain exposure to Brazilian and Mexican bonds via an ETF can consider the Market Vectors LatAm Aggregate Bond ETF (NYSE:BONO). BONO has a distribution yield of 4.51 percent and if Goldman's prediction that short-term Brazilian bonds have priced in the bulk of the central bank's rate-hiking agenda, the ETF could offer some upside in the back half of this year.

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