S&P: Not Much to Like With EM Bond ETFs

Long emerging markets bond ETFs may be yesterday's trade (not actually yesterday), but traders know what that statement means. However, the woes and subsequent repudiation of this asset class are today's, last week's and last month's headlines.

Stung by the specter of receding Federal Reserve stimulus, the emerging markets label on any asset class might as well read "Do Not Touch."

That sentiment is particularly evident with ETFs that hold emerging markets debt. It does not matter if the debt is sovereign or corporate; investment-grade or junk; dollar-denominated or local currency. Due to a raft of protests, tumbling currencies and the looming loss of U.S. easing investors are running away from developing world bond funds.

While S&P Capital IQ analyst Alec Young "isn't surprised that EM assets have succumbed to sharp selling pressure, as the magnitude of future stimulus has come into question amid an improving U.S. economic outlook that has markets discounting an accelerated Fed tapering timeline," said the research firm in a new note, the analyst "believes, the open-ended nature of the Fed tapering overhang should continue to limit rallies and fuel continued EM underperformance over the coming months. After all, U.S. interest rates - while up sharply from mid-May - remain historically low, leaving plenty of room for additional rate increases to further undermine already fragile investor EM sentiment."

As a result, S&P Capital IQ has tepid to bearish views on some emerging markets bond ETFs. The Market Vectors Emerging Markets Local Currency Bond ETF (NYSE:EMLC), which is down 10 percent in the past month, earned a Marketweight rating from S&P.

That rating is not terrible considering EMLC currency exposures read like a who's who of downtrodden currencies. The Brazilian real, Mexican peso, South African rand and Turkish lira combine for over 36 percent of EMLC's currency weight.

"Many major emerging nations are now expected to post weaker growth in 2013 than last year. These include China, India, Indonesia, Mexico, Russia, Poland, Peru and Chile. In addition, many others like Brazil and Turkey, which are still expected to top 2012's paltry growth rates, have recently faced popular unrest, highlighting that risks are firmly to the downside," said S&P Capital IQ in the note.

The iShares Emerging Markets High Yield Bond Fund (NYSE:EMHY) has been plagued by similarly concerning country exposures. As if Turkey and the Philippines combining for 26 percent of EMHY's weight is not bad enough, Venezuela garners a weight of 15.5 percent in the ETF and there is talk of another bolivar devaluation. EMHY is down 11.2 percent in the past month and S&P rates that ETF Underweight.

S&P also has a lukewarm view on the dollar-denominated iShares J.P. Morgan USD Emerging Markets Bond Fund (NYSE:EMB). EMB, the largest emerging markets bond ETF by assets, garnered a Marketweight rating. EMB is down 10 percent in the past month and although the ETF is dollar-denominated, it's country exposures are no more attractive than the other funds highlighted in the S&P note.

Russia, Turkey, Brazil, Mexico, Indonesia and the Philippines combine for nearly 38 percent of EMB's weight.

"Emerging Market Sovereign bond spreads over the 10-year U.S. Treasury have widened from 2.5% in January 2013 to above 3.7% in recent days. Given the EM underperformance Young expects for the coming months, S&P Capital IQ thinks investors who have long come to expect capital appreciation potential for fixed income ETFs offering emerging market exposure should be more cautious," said S&P.

The other thing that is widening is credit default swaps used to insure $10,000 worth of sovereign debt for five years. Well, CDS on Chinese and Brazilian debt are widening. CDS on Chinese debt are at their highest levels in over a year while swaps on Brazilian debt are at the highest levels since 2011, according to Bespoke Investment Group.

Emerging markets corporates offer advantages such as lower durations and higher yields over their U.S. peers, but that has not stopped the iShares Emerging Markets Corporate Bond Fund (BATS: CEMB) from falling 10.2 percent in the past four weeks. S&P Capital IQ has an Underweight rating on that ETF.

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