Emerging markets bonds, even the investment-grade issues, share a couple of things in common with junk bonds. Of course, both are prized for yields that are superior to developed markets government debt. Both were among investors' most favored bond ETF destinations in 2012.
The similarities do not end there. Albeit to a less extent than U.S. high-yield corporates, emerging markets bonds are dealing with bubble talk. Plug the phrase "emerging markets bond bubble" into Google and nearly 1.7 million results are returned in less than a third of a second.
That does not mean there are no more opportunities with developing markets debt. Quite the contrary in the eyes of one portfolio manager. Non-dollar denominated issues could represent the best opportunities for bond investors this year.
"That is a positive part of the value proposition we today emerging markets currencies are not undergoing the same monetary experiment that could lead to a debasement of the world's reserve currencies," said Market Vectors portfolio manager Fran Rodilosso.
Dollar-denominated emerging markets bond ETFs not only soared in terms of returns last year, two of this sub-segment's largest funds also surged in popularity with investors. The PowerShares Markets Sovereign Debt ETF (NYSE:PCY) is up about 15.3 percent in the past year and has seen its assets under management total jump to almost $3.1 billion as of January 18 from $2.5 billion in early November 2012.
The rival iShares J.P. Morgan USD Emerging Markets Bond Fund (NYSE:EMB) has returned nearly 12 percent in the past year. EMB had $6.2 billion in AUM in early November, but that number is now north of $7 billion.
Amid rampant developed market monetary easing and currency debasement, this year could be different for dollar-denominated bonds.
"The first step for investors is to realize that many traditional fixed income investments are not likely to deliver the same types of returns we saw in 2012," said Rodilosso in a statement.
"Although one approach some investors might apply this year is to add leverage, doing so has often proven to be a perilous proposition. Instead, I believe the time may be right to consider emerging markets destinations that offer more attractive yields on top of currency and credit fundamentals that appear to me to be on much more solid footing than the U.S. dollar, euro or yen investments."
Rodilosso is the portfolio manager for the popular Market Vectors Emerging Markets Local Currency Bond ETF (NYSE:EMLC), so some might argue that his preference for non-dollar developing world bonds should be taken with a grain of salt. However, there is no denying that ETFs such as EMLC have caught investors' attention.
EMLC, which has a 30-day SEC yield of 4.76 percent, crossed the $1 billion in AUM mark in the fourth quarter and now has $1.27 billion in AUM, according to Market Vectors data. Importantly, this fund and others like it do not represent significant increases in credit risk. For example, nearly 60 percent of EMLC's holdings carry investment-grade ratings.
Brazil, Poland, South Africa and Mexico each receive allocations of 10 percent in EMLC. The ETF has gained almost nine percent in the past year. Rodilosso noted that the J.P. Morgan GBI-EMG Core Index (GBIEMCOR), EMLC's underlying index, rebalanced to include Nigeria at the end of last year. Africa's largest oil producer now receives a three percent weight in EMLC. Romania is now eligible for inclusion and Romanian debt will begin entering the index on March 1st, according to the portfolio manager.
Other local currency funds have proven adept at attracting investors' cash. The iShares Emerging Markets Local Currency Bond Fund (NYSE:LEMB) had $207 million in AUM at the end of October, but that total now stands at $405.4 million. South Korean and Brazilian issues combine for 34 percent of LEMB's weight and the bulk of the fund's 80 holdings garner investment-grade ratings from Moody's Investors Service.
Even with the soaring inflows to local currency funds, Rodilosso still sees money managers as under-allocated to the space and that could spell more upside for these funds this year as more professional investors warm to the ideas of emerging markets' significantly lower debt-to-GDP ratios, fiscal deficits and higher interest rates.
"It is still my belief that global asset managers remain under-allocated when it comes to local currency emerging markets debt," he said. "Perhaps this is due to some investors' tendencies to associate emerging markets in general with past boom/bust cycles. Add to that the fact that the relative strength of emerging markets may in itself be something that many investors are finding difficult to digest, let alone believe in enough to allocate significant capital, and that may very well be why we're seeing value remaining in these markets."
Other ETF ideas in the local currency emerging markets space include the WisdomTree Asia Local Debt ETF (NYSE:ALD), which tracks a region with some of the emerging world's best growth prospects for 2013.
Rodilosso also serves as the manager for the MarkVectors Fallen Angel High Yield Bond ETF (NYSE:ANGL), the Market Vectors Emerging Markets High Yield Bond ETF (NYSE:HYEM) and the Market Vectors Renminbi Bond ETF (NYSE:CHLC), among others.
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