Knowing What's In Your EM Bond ETF

Helped in part by the disappointing dollar, some emerging-market currencies have been solid performers this year, providing support for bonds denominated in those currencies. For example, the Market Vectors Emerging Mkts Local ETF EMLC is up 8 percent year to date compared to a gain of less than 5 percent for the largest emerging-market bond exchange-traded fund that holds dollar-denominated bonds.

EMLC is nearly 7 years old and home to $3.2 billion in assets under management, making it one of the oldest and largest emerging-market bond ETFs with local currency-denominated holdings. The ETF tracks the JPMorgan GBI-EMG Core Index and holds 254 bonds.

One of the most obvious reasons explaining the popularity of ETFs such as EMLC is yield, pure and simple. With trillions of dollars of negative-yielding floating around throughout the developed world, EMLC's 30-day SEC yield of 5.56 percent is undoubtedly enticing. While EMLC holds sovereign bonds, investors should still examine the credit ratings of the issuers of bonds in this and other emerging-market bond ETFs.

Junk Is Piling Up

“Why worry about the 'junk'? Because there is more of it,” said VanEck in a recent note.

“Moody's downgrade of China in May received the most attention, but had less impact on investors given its lack of presence in emerging markets bonds indices. On the other hand, Brazil and South Africa suffered ratings downgrades that have had a greater impact for investors. Both countries have been punished by elevated political risks that have threatened key fiscal and economic reforms. South Africa was downgraded by both S&P and Fitch from investment grade status to high yield status. Brazil, which was placed on negative watch by S&P, lost its investment grade rating in 2015.”

Brazil and South Africa combine for 16.4 percent of EMLC's weight. The ETF features no exposure to Chinese debt. EMLC's two largest country weights are Poland and Mexico. That duo combines for over 19 percent. Nearly 20 countries are represented in the ETF.

Considering Credit Quality

Unfortunately, emerging markets' credit quality is worsening while spreads are tightening, meaning investors are not getting adequate compensation for the risk associated with some developing world debt.

“This means that emerging markets bonds investors are likely to have more 'junk' in their portfolios, and are assuming significantly more credit risk than they were only four years ago,” said VanEck. “Since 2013, the average emerging markets bond rating has dropped from BBB- to BB+. At the same time, yields and spreads have tightened, and investors are getting paid less to assume more risk.”

Fortunately, EMLC is a mostly investment-grade portfolio. More than two-thirds of the ETF's holdings carry investment-grade ratings while fewer than 14 percent are rated junk. The remainder are not rated.