EM Bond ETFs Look Poised for 2013 Upside

Following a 2012 that saw a batch of solid returns for emerging markets bond ETFs denominated in local currencies, this sub-sector the exchange-traded products universe has seen tepid performances to start 2013.

However, with investors and money managers still looking for ways to boost portfolio income, emerging markets local currency debt could deliver upside as this year progresses.

As most investors know, U.S. Treasuries and high-grade corporates offer minimal income potential, but the same cannot be said of emerging markets local currency bond ETFs. For example, the WisdomTree Emerging Markets Local Debt Fund (NYSE:ELD) has a 30-day SEC yield of 3.77 percent.

Conversely, the 30-day SEC yield on the iShares Barclays TIPS Bond Fund (NYSE:TIP) is negative 4.17.

At the end of January, ELD had a yield to maturity of 4.59 percent and a duration of of 4.84 years. The comparable five-year U.S. Treasury Note has a comparable duration of 4.8 years. Duration is the measure of a bond's sensitivity to interest rate changes.

With over $1.8 billion in assets under management, ELD is coming off its best calendar year performance since inception in 2010, according to WisdomTree. Not to mention, ELD, the second-largest actively managed ETF, has been an impressive gather of assets in recent months. As recently as early in the fourth quarter of 2012, ELD had just over $1 billion in assets.

Soaring to $1.8 billion in just a few months is undoubtedly impressive and there are reasons why investors continue to embrace this asset class.

"In fact, emerging market local debt as an asset class had better returns than even high-yield debt in 2012 thanks to aggressive interest rate cuts by many EM central banks," said WisdomTree Portfolio Manager Rick Harper in a note. "While the future path of U.S. fixed income may be subject to debate, we believe investors should also be focusing on the potential drivers of return in international fixed income and emerging markets when making portfolio allocation decisions."

Those potential drivers of returns to emerging markets debt in 2013 include the possibility that select developing world currencies are poised to bounce back against the U.S. dollar this year and the thesis that some emerging markets could earn higher credit ratings.

Additionally, as Harper previously noted, developing world central banks are largely on hold with regards to interest rate cuts. That removes an obvious hurdle to currency appreciation in those markets.

"With less central bank activity, we believe interest rates in emerging market government debt will remain near current levels in 2013," said Harper in the note.

While noting that ELD's returns since inception have been hampered by currency performance, Harper believes in the long-term prospects for emerging markets currencies.

"The rationale behind this belief is that as these countries continue to grow at faster rates than the U.S., there may be a bias for the currency to appreciate against the U.S. dollar. Eventually, as these countries transition from export-driven economies to more consumer-based ones, an appreciating currency will benefit as they import more products from abroad," he said.

ELD offers exposure to 15 countries with Mexico, Indonesia and Malaysia each receiving allocations of more than 10 percent. Brazil, Russia and Thailand are also include among the top-10 country weights.

The ETF is also worth considering for investors looking to profit from possible ratings upgrades. At least three of ELD's country holdings Colombia, Turkey and the Philippines have the potential to be on the receiving end of favorable ratings agency news this year.

For more on emerging markets bonds, click here.