Finding Quality With EM Bonds

Thanks to piddly U.S. Treasury yields and trillions of dollars' worth of negative-yielding sovereign debt elsewhere in the developed world, fixed income investors are finding their way back to emerging markets bonds and the related exchange-traded funds this year.

Emerging markets sovereign debt is one of this year's best-performing asset classes, a trend that is benefiting an array of exchange-traded funds. Some ETF issuers are seizing upon that theme by bringing new products to market, including the VanEck Vectors ETF Trust Market Vectors EM Investment Grade + BB Rated USD Sovereign Bond ETF (NYSE:IGEM).

Searching For Quality In IGEM

IGEM, which is about a month old, follows the J.P. Morgan Custom EM Investment Grade Plus BB-Rated Sovereign USD Bond Index (JPEGIGBB), which is comprised primarily of investment grade U.S. dollar-denominated bonds issued by emerging markets (EM) governments, according to VanEck.

Investors should not pass judgment, good or bad, on ETFs that are just a month, but IGEM is off to a solid start with over $15 million in assets under management. Understanding investors' enthusiasm for the new ETF is easy. IGEM has a 30-day SEC yield of 2.97 percent, or 142 basis points above Monday's closing yield on 10-year Treasurys.

From a yield perspective, lower rated bonds tend to provide higher yields versus those with higher ratings. This should not be surprising since a higher yield is reflective of a higher spread which incorporates, among other factors, a higher risk of default. Investment grade emerging markets bonds had an average yield of 3.91 percent as of July 31, 2016 compared to a yield of 6.95 percent on bonds with high yield ratings. Breaking that down further, its clear that the yield pickup becomes increasingly large between the BB-rated and B-rated categories, said VanEck in a recent note.

Risk/Reward

Investors are not taking on significant credit risk with IGEM. For example, Mexico and the Philippines combine for over 16 percent of the ETF's weight, and those are two of the higher-rated emerging markets. Conversely, Brazil, which is rated junk by at least one ratings agency is just 4.6 percent of IGEM's lineup.

Indonesia, another hefty member of IGEM's roster, is home to some of the best-performing debt in the emerging world this year, further cementing the ETF's status as a quality play on an asset class some investors do not always associate with quality.

Overall, investors who maintained exposure to investment grade emerging markets sovereign bonds, with an allocation to BB-rated bonds or 20 percent, would have earned 7.55 percent over the past ten years versus 7.83 percent on the broader emerging markets sovereign index, with lower volatility and higher risk-adjusted returns as measured by the Sharpe ratio, added VanEck.

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