An Idea for Hedging Risk in Emerging Markets Bond ETFs

Emerging markets bond exchange traded funds funds have been decimated by a vicious circle. Global investors think the Federal Reserve will soon be raising interest rates, which has forced Treasury yields higher, dragging the U.S. dollar along for the ride. In turn, emerging currencies have tumbled and fears that some issuers in the developing world will not be able to adequately surface debt in the face of a strong dollar/weak local currency environment.

Even some actively managed emerging markets bond funds have been unable to escape the dollar's wrath. For example, the WisdomTree Emerging Markets Local Debt Fund ELD is off 10 percent this year. However, investors looking to grab some yield while bottom-fishing with local currency funds can do so while employing a professional-level hedge that is rather simple: A 50/50 split between an ETF like ELD and the WisdomTree Bloomberg U.S. Dollar Bullish Fund UDSU.

“In our view, a bullish dollar position against a broad-based basket of developed and emerging market currencies provides a powerful option for managing currency risk in a portfolio of emerging market assets. In the discussion below, we put this concept in practice by combining a bullish dollar strategy1 with an emerging market local debt strategy.2 In our view, emerging markets provide some of the most compelling valuations around the world. Employing a bullish dollar strategy as a hedge for EM currency risk could be a cost-effective way to reduce volatility, particularly in advance of a shift in Federal Reserve (Fed) policy,” said WisdomTree in a note out Monday. 

USDU, which is also actively managed, is up 6.3 percent this year, helping investors that have employed the aforementioned strategy cope with some of the losses incurred by the long ELD position. USDU is particularly useful as a hedge against long positions in emerging markets local currency bond funds because it is the only dollar ETF that measures the greenback's strength against developing world currencies.

For example, Mexico, South Korea, China and Brazil combine for over 18 percent of USDU's weight. Those are positive traits at a time when the Mexican peso and Brazilian real are hovering near multi-year lows against the dollar. 

“In this blended approach to emerging markets, investors are able to maintain exposure to the emerging market assets while dampening the overall drawdowns and volatility of their investment. As we have seen so far in 2015, emerging markets can experience volatility on the upside as well as the downside.4 By combining legacy EM fixed income positions with a bullish dollar strategy, investors may be able to limit the impact of changes in global monetary policy,” notes WisdomTree.

Perhaps the biggest advantage of an idea such as long ELD/long USDU is the trade's ability to reduce correlations. Using USDU's underlying index and the JP Morgan GBI-EM Global Diversified Index for the 50/50 split, WisdomTree data indicate a negative correlation of -0.81 with downside risk of 2.78 percent, or about 630 basis points below that of being long the bond index without the protective currency hedge.