An Even Hotter Way To An Already Hot ETF Trade

Bonds and fixed-income exchange-traded funds are hot this year, and within that space, emerging markets bond funds are scintillating.

As has been noted throughout the course of this year, the Federal Reserve's refusal to raise interest rates is capping the dollar's ability to muster much momentum. In turn, yields are coming down on emerging markets bonds because issuers' external financing needs are not as crimped as they were when the greenback was soaring in anticipation of multiple rate hikes.

Enticing ETFs

The two largest emerging markets bonds ETFs each hold dollar-denominated debt and those funds are up an average of 15.5 percent. However, with the dollar weak, that means previously downtrodden emerging currencies are soaring, breathing new life into ETFs that hold emerging markets bonds denominated in local currencies.

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Although such ETFs are usually more volatile than their dollar-denominated counterparts, these funds should reward investors for a little extra risk. For example, the Market Vectors Emerging Mkts Local ETF EMLC is higher by 17.4 percent year-to-date, a significant advantage over its dollar-denominated rivals.

“Investors' renewed interest in emerging markets debt amid the yield drought in developed markets is evidenced by the surge in flows this year that accelerated in July. According to J.P. Morgan, during the month, global flows amounted to an estimated $13.7 billion, almost 60 percent of year-to-date flows of $23.3 billion. Inflows of $4.7 billion toward the end of the month exceeded the previous weekly record set earlier in the month. Almost all flows have been into hard currency strategies, with local currency flows slightly positive at $0.7 billion,” according to a VanEck note.

Getting Excited Over EMLC

It is easy to understand investors' enthusiasm for emerging markets debt, dollar-denominated or local currency. German and Japanese 10-year sovereigns have negative yields. The comparable U.S. bond yields just over 1.5 percent.

However, as VanEck data noted, the 10-year bond in Brazil yield 11.4 percent at the end of July. The same bond in Turkey sported a yield of 9.5 percent. Even relatively steady Chile offers 4.5 percent on its 10-year sovereigns. Brazil, Turkey and Chile, in that order, combine for 16.8 percent of EMLC's weight. The ETF has a 30-day SEC yield of 5.5 percent.

“The search for yield seemed to outweigh concerns stemming from events in Turkey, the growth impacts of Brexit, and a decline in current oil prices. Emerging markets corporates had a strong July, returning 1.59 percent largely due to spread tightening. Hard currency sovereigns posted strong July performance of 1.80 percent, outperforming local currency bonds which returned 0.60% in U.S. dollar terms, with currencies impacting performance negatively. Despite the compression in yields, spreads on hard currency sovereigns remain slightly wider versus their 10-year historical average,” added VanEck.