Venezuela's Woes Are Barely Felt By Emerging Market Bond ETFs

Venezuelan sovereign bonds have been among the world's most volatile. On Wednesday, the South American country unveiled a debt restructuring deal with Russia and, separately, earned words of encouragement from another major creditor: China.

Earlier this week, S&P Global Ratings said Venezuela was in selective default on two its bond issues, maturing in 2019 and 2024. On Tuesday, Fitch Ratings downgraded Venezuela's Long-Term Foreign Currency Issuer Default Rating to RD," or restricted default, from C. The controversy surrounding Venezuela's ability to repay its debts is not hampering exchange traded funds holding the country's bonds.

Venezuelan bonds are found in many hard-currency emerging-markets debt ETFs, but the majority of these funds are passively managed and the indexes they track do not have significant exposure to Venezuelan debt. For example, the iShares J.P. Morgan USD Emerging Markets Bond ETF (NASDAQ:EMB), the largest emerging markets bond ETF, allocates less than 1.3 percent of its weight to Venezuela's sovereign debt.

EMB can hold bond defaults as highlighted by previous exposure to Ukraine and Argentina, but weights to defaulted bonds typically decline in the fund's index. As that debt is restructured, EMB's index can increase its weight to those bonds.

Allocations Matter

At present, there is no meaningful amount of local-currency Venezuelan debt outstanding thanks to the country's hyperinflation, said Morningstar. Hyperinflation has all but wiped out the value of the country's local-currency debt as the government has kept printing more money to meet its obligations. As a result, the country's bolivar-denominated domestic debt is essentially worthless, which explains why only hard-currency Venezuelan debts are owned by virtually all emerging-markets bond funds.

What that means is that local currency bond ETFs are unlikely to hold Venezuelan bonds. The $4.2 billion VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (NYSE:EMLC) holds 270 bonds denominated in local currencies. Although a significant portion of that ETF's geographic exposure lies in South America, EMLC features no bolivar-denominated issues.

Reminders

The PowerShares Emerging Markets Sovereign Debt Portfolio (NYSE:PCY) has $4.9 billion in assets under management and is the second-largest dollar-denominated emerging markets bond ETF behind EMB.

With just 83 holdings, PCY's roster is small compared to rivals such as EMB and EMLC. PCY holds previous defaults, including Argentina and Ukraine, as well as some speculative CCC-rated issues, but the ETF has a Venezuela weight of just 1.7 percent.

The Venezuelan debt situation is a good reminder for investors how important it is to understand the inner workings of indexes tracked by ETFs, said Morningstar. In the process of digging in, investors will recognize that most emerging-markets debt ETFs' Venezuelan exposure comprises less than 3 percent of their portfolio.

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