A Familiar Problem For Emerging Market Bond ETFs

The iShares J.P. Morgan USD Emerging Markets Bond ETF EMB, the largest exchange-traded fund tracking developing world debt, is down about 5.6 percent this year and it's not hard to explain why.

EMB tracks the JPMorgan EMBI Global Core Index. As the fund's name implies, its holdings are comprised of dollar-denominated debt. In previous eras of dollar strength, the stronger greenback has pinched emerging markets debt, a scenario that appears to be at play again this year.

What Happened

Catalysts that previously lifted emerging markets debt are ebbing. EMB rose 10.3 percent last year even as the Federal Reserve raised interest rates three times. The emerging markets bond fund was able to weather that rate storm because the greenback was weak and commodities prices firmed.

“The benefits of a weak dollar and rising commodity prices, which supported strong emerging-market (EM) growth in 2017, are now beginning to fade,” said Fitch Ratings. “This will leave EM issuers facing more challenging economic and financial conditions as interest rates rise and central bank monetary policy becomes less accommodative.”

Why It's Important

A stronger dollar usually weighs on commodities prices, which is problematic for many developing economies because many are major commodities producers. At least seven of EMB's top 10 country weights can be considered major commodities producing nations. That group includes Mexico, Russia, Brazil and Colombia.

A stronger greenback also means higher external financing costs for emerging markets that issued dollar-denominated debt. If the dollar remains strong for an extended period of time, some developing economies could be vulnerable to sovereign credit rating downgrades.

“EM debt securities outstanding have ballooned to USD19.3 trillion, up from USD5 trillion a decade ago. China accounts for more than half (USD11 trillion), up sharply from only USD1.5 trillion in 2007,” said Fitch.

What's Next

There are no guarantees of this scenario repeating, but there have been times when EMB and the U.S. Dollar Index have declined or risen in the same year. That happened from 2013 through 2016, but that trend ended last year as the dollar plunged.

"The US dollar had remained surprisingly weak after the Fed began its rate rise cycle in December 2015 but it has recently started to rise as Treasury yields hit 3 percent at the end of April,” said Fitch. “Some countries have therefore felt increasing pressure on their currencies, notably Argentina, Turkey and Brazil.”

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