Pedal To The Metal For These Bond ETFs

No, that headline is not referencing U.S. government bond exchange-traded funds; although, given the stellar performances turned by such funds this year, it is a good guess. Rather, the headline references a once fragile asset class and its corresponding ETFs: dollar-denominated emerging markets bonds.

Circle back to the various instances of taper tantrums over the past several years prior to the Federal Reserve raising rates for the first time in nearly a decade in December, and ETFs such as the iShares JPMorgan USD Emer Mkt Bnd Fd ETF (NYSE:EMB) and the PowerShares Emerging Markets Sovereign Debt Portfolio (NYSE:PCY) displayed their vulnerability to even slight speculation that the Fed could be nearing hawkish action.

Quantitative Easing, Emerging Markets And Hawkish Action

The situation was pretty easy to figure out. Emerging markets governments and some corporations binge borrowed in dollars during the various versions of the Fed's quantitative easing programs. It looked smart as the dollar weakened against a plethora of developed and emerging currencies, but those emerging markets borrowers were caught off guard when the dollar started soaring several years ago.

Things are better for dollar-denominated emerging markets bonds this year, as highlighted by the average 4.8 percent year-to-date return offered by EMB and PCY. That matches the performance of the Vanguard Emerging Markets Stock Index Fd (NYSE:VWO), the largest emerging markets equities ETF. Not only that, but emerging markets debt has turned in better performances than a surprising a cast of rivals.

Dollar-Denominated Emerging Markets Bonds

Since January 2016, dollar denominated EM sovereigns and corporates have returned 4.3 percent and 3.2 percent respectively, according to Markits iBoxx indices. The returns surpass those of developed markets, beating US treasuries (2.7 percent), German bunds (3.6 percent) and US investment grade bonds (2.9 percent), said Markit in a new research note.

EMB and PCY compensate investors for the risk that comes along with emerging markets bonds as these ETFs sport 30-day SEC yields of 5.1 percent and 5.6 percent, respectively. EMB is a bit more traditional in its constitution as Mexico, Russia, Indonesia and Turkey combine for about 23 percent of that ETF's weight.

To get through PCY's top 10 holdings, investors will see bonds issued by the governments of Latvia, Serbia and Morocco, among others, but 53 percent of that ETF's lineup is rated BBB, A or AAA. PCY has an effective duration of 8.4 years, while EMB's is just over seven years.

Sovereign bonds have enjoyed a more sustained rally over the past two months. The Markit iBoxx USD Emerging Markets Sovereigns index has enjoyed above average returns for the past X consecutive, with the past two months featuring in the top list for monthly returns post financial crisis. The only other consecutive months in the list are from late 2013, as emerging markets rallied post 'taper tantrum' fears, added Markit.

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