A Pleasant ETF Surprise That Could Continue In 2016

Investors in emerging markets equities and the relevant exchange traded funds probably cannot wait for 2015 to be over in the hopes that the worst is behind the struggling asset class. Big losses for the Vanguard FTSE Emerging Markets ETF VWO and the iShares MSCI Emerging Markets ETF EEM, the two largest emerging markets ETFs, confirm as much.

If there has been a pleasant surprise courtesy of developing economies this year, it comes courtesy of their debt markets. Despite obvious concerns that an array of emerging markets would be plagued by higher U.S. interest rates due to their expanding levels of dollar-denominated debt, the iShares J.P. Morgan USD Emerging Markets Bond ETF EMB is down just 3.4 percent year-to-date. That is significantly better/less bad than the almost 17 percent lost by the MSCI Emerging Markets Index.

“This outperformance is surprising not only because it has occurred amid pervasive negative sentiment toward EM assets, but also because it’s happening as the Federal Reserve (Fed) is poised to raise interest rates. The last time investors digested tighter monetary policy from the Fed in the summer of 2013, an event now recognized as the so-called “Taper Tantrum“, the EMBIG index suffered a -5.25 percent return that year, performance very different from what we’ve seen this year and last, according to data from Bloomberg,” said BlackRock Global Chief Investment Strategist Russ Koesterich in a new note.

The $4.6 billion EMB has arguably been remarkably durable considering its country lineup. Though the ETF's largest country allocation is almost 6.7 percent to Mexico, there is the nearly 5.6 percent weight to Russia, a country that is struggling amid lower oil prices and coping with its worst post-Soviet era recession.

Then there is the nearly four percent weight to Brazil, another major commodities exporter that is enduring a spate of controversy, calls for President Dilma Rousseff's job and credit ratings downgrades, including at least one to junk status.

Interestingly, it has been high-yield debt that has been bolstering emerging markets bonds. For its part, EMB has a 30-day SEC yield of 5.37 percent.

“Since April, according to a BlackRock analysis using J.P. Morgan data, debt from IG countries has contributed very little, or in some cases detracted, from the asset class’s total performance, while debt from HY countries has done the heavy lifting, as the chart below shows. While this positive performance is welcome, it hasn’t been broad based. For example, Russian debt, which received a downgrade to HY at the start of the year, is contributing 66 percent of the EMBIG index’s 2015 return,” adds Koesterich.

EMB is far from a risk-free bet. The ETF allocates nearly nine percent of its combined weight to Turkey and South Africa, two countries that are flirting with downgrades to junk status.