Emerging Markets May Be Ready For a Reset

After pulling back in face of falling commodity prices, a stronger U.S. dollar and slowdown in China, emerging market bond exchange traded funds have stabilized and now offer attractive valuations, providing fixed-income investors exposure to strengthening fundamentals in the developing economies.

"The longer-term fundamental rationale for investing in emerging markets remains intact," William Sokol, Product Manager of ETFs at VanEck, said in a research note. "This is perhaps best characterized by the higher economic growth that emerging markets have enjoyed versus developed markets, over several decades."

While emerging markets have been known for their rapid growth, many have maintained manageable debt levels through controlled borrowing, whereas many developed countries have seen debt-to-GDP rations rise in recent years to fuel their economic recoveries.

The recent strength in the U.S. dollar has been a cause for concern as many emerging countries issued debt denominated in U.S. dollars, which make it harder for governments to service the debt if their local currencies depreciate or the USD strengthens. Moreover, the stronger USD could trigger capital flight as investors pull out of vulnerable markets, causing emerging countries to deplete currency reserves to defend their currencies.

Many emerging economies, though, have adopted flexible exchange rates and central banks have shown greater willingness to use flexible rates as shock absorbers during more volatile conditions. Recent global downturns have revealed the resilience of the emerging markets that adopted lower external debt, higher reserves and greater fiscal flexibility.

"We’ve seen many long-term, fundamental driven investors gradually increasing their exposure to EM local currency debt this year, after perhaps being underallocated in recent years," Sokol said in an email.

Given the recent dips and supportive long-term outlook in the emerging market bond market, investors may consider local-currency emerging bond ETF strategies that focus on local currency-denominated debt, which have less default risk in periods of a strengthening USD.

"We’re clearly not seeing the outflows that hard currency funds experienced," Sokol added. "For income seeking investors who believe in the long-term fundamental story of emerging markets, the increase in EM local currency bond yields since the election represents attractive value. Further, the higher carry that EM debt generates, whether from local or hard currency bonds, provides valuable protection and stability against the higher rates and currency volatility we’ve seen the past few weeks."

Investors can gain broad exposure to yield-generating emerging market local currency bonds through ETF offerings. For instance, the VanEck Vectors Emerging Markets J.P. Morgan EM Local Currency Bond ETF (NYSEArca: EMLC) has a 6.02% 30-day SEC yield. Its top country exposure include Poland 9.4%, Brazil 8.7%, Indonesia 8.6%, Mexico 8.6% and South Africa 7.8%.

The iShares Emerging Markets Local Currency Bond ETF (NYSEArca: LEMB) has a 5.40% 30-day SEC yield. Top country weights include South Korea 20.5%, Brazil 14.0%, Mexico 6.7%, Czech Republic 4.5% and Indonesia 4.5%.

The actively managed WisdomTree Emerging Markets Local Debt Fund (NYSEArca: ELD) has a 7.35% 30-day SEC yield. The fund’s largest weights include Brazil 10.9%, Russia 10.6%, Thailand 10.4%, South Africa 7.2% and Mexico 7.0%.

The SPDR Bloomberg Barclays Emerging Markets Local Bond ETF (NYSEArca: EBND) has a 5.40% 30-day SEC yield. The top country components include Brazil 12.7%, South Korea 12.4%, Mexico 8.4%, Indonesia 7.5% and Malaysia 7.5%.

This article was provided courtesy of our partners at etftrends.com.