Looking For Good Credit Among EM Bond ETFs

When it comes to investing in bond ETFs, one of the most important factors investors can (and should evaluate) is the credit quality of the fund's holdings. Arguably, credit quality takes on added importance when analyzing ETFs that offer exposure to emerging markets debt.

In the years immediately following events such as Asian debt crisis of the late 1990s, Russia default crisis in 1998 and Argentina's sovereign default in 2001, conventional wisdom held that bond investors faced increased credit risk in the emerging world. That is not necessarily the case anymore as plenty of emerging markets or either poised to see higher credit ratings or have recently been on the receiving end of upgrades.

As was widely expected, the Philippines recently joined the investment-grade club when Fitch long-term, foreign currency-denominated debt to BBB- from BB and the long-term local currency-denominated debt to BBB from BBB- with stable outlooks on both ratings.

As WisdomTree Portfolio Manager Rick Harper notes, on the same day, Standard & Poor's upgraded Turkey's local currency debt to BBB, which is the second-lowest investment-grade rating.

"While this represents an important milestone for the Philippines, we believe it also serves as positive reinforcement for our focus on fundamentals when investing in emerging markets," said Harper in a research note. In uncertain or developing markets, biasing a portfolio toward stronger economic fundamentals could be a prudent way of reducing risk. In its report, Fitch noted that the impressive gross domestic product (GDP) growth of 6.6% in 20123 and a projected expansion of 5.5% in 20134 make the economy all the more attractive, given its comparatively low debt burden."

At the end of last year, S&P raised its outlook on the Philippines to positive, citing the positive impact of policies set forth by President Benigno Aquino.

The investment-grade rating for the Philippines has been good news for the WisdomTree Emerging Markets Local Debt Fund (NYSE:ELD) and the WisdomTree Asia Local Debt Fund (NYSE:ALD). The two actively managed ETFs hold allocations to the Philippines of 3.72 percent and 5.73 percent, respectively. ELD, which is the second-largest actively managed ETF on the market today with over $1.9 billion in assets under management, also features a seven percent weight to Turkey.

Following the Philippines and Turkey news, all of 15 of the countries featured in ELD have an investment-grade rating by at least on major ratings agency for the first time since the ETF debuted in August 2010, said Harper. Same goes for ALD. All 12 of the countries in that ETF now have investment-grade ratings from at least one of the major ratings agencies.

In the case of ELD, the diminished credit risk highlights the strong fundamentals surrounding this ETF. Nearly half the ETF's holdings are rated either, AAA, AA or A.

ELD's effective duration is 4.86 years, which is slightly lower than the 5.05 years seen on the rival Market Vectors Emerging Markets Local Currency Bond ETF (NYSE:EMLC). Mexico, Malaysia, Indonesia and Brazil combine for nearly 42 percent of ELD's weight. The Mexico exposure is significant because investors have shown a robust appetite for Mexican debt in recent months.

For its part, ALD is not a pure emerging markets plays. In fact, the $547 million ETF offers ample developed market exposure and that means over 62 percent of its holdings are rated AAA, AA or A. With ALD investors get the benefit of exposure to AAA-rated Australia, Hong Kong and Singapore along with the solid yields offered by AA-rated New Zealand. Those four countries combine for about 29 percent of ALD's weight, though Thailand is ALD's largest country weight at 11.87 percent.

ALD is also attractive regarding sensitivity to interest rate increases with an effective duration of just 3.52 years, according to WisdomTree data. ALD's average yield to maturity is 2.73 percent.

"Ultimately, we are heartened by the progress being made in many emerging market countries. As investors continue to look for higher yield potential globally, we believe interest in the asset class could continue to grow in the coming years," said Harper.

For more on emerging markets bonds ETFs, click here.