Expect More China In These ETFs

China is poised to command a larger percentage of equity-based emerging markets exchange traded funds thanks to index provider MSCI Inc.'s MSCI plan to boost its international benchmarks' exposure to A-shares, the stocks trading on mainland China.

That news was announced earlier this year and it's not the only big news pertaining to China's footprint in emerging markets indexes and the related ETFs.

What Happened

China's massive yuan-denominated bond market is opening up to international investors, which could mean the country will become part of the lineups in local currency emerging markets bond ETFs, such as the iShares J.P. Morgan EM Local Currency Bond ETF LEMB.

“China’s local-currency bond market is opening up to global investors,” said BlackRock in a recent note. “The Bloomberg Barclays Global Aggregate Index begins including yuan-denominated bonds this month, automatically adding exposure to such bonds for index investors. We favor maintaining such passive exposure and preparing to invest more.”

Why It's Important

As its name implies, the $665 million LEMB tracks a JPMorgan index, specifically, the J.P. Morgan GBI-EM Global Diversified 15% Cap 4.5% Floor Index. JPMorgan is consulting with clients about the inclusion of yuan-denominated bonds in its international bond benchmarks and could announce a decision to that effect in the next several months.

China's bond market is valued at $13 trillion, making it the world's third-largest. LEMB has no exposure to China. The ETF has exposure to nearly 20 countries with Brazil and Mexico, Latin America's two largest economies, combining for 21.43 percent of the fund's weight.

“The inclusion of local-currency government and policy bank securities into the global bond market benchmark index is set to gradually occur over a 20-month period,” according to BlackRock. “Those passively invested in that index will, by default, add Chinese bond exposure to their holdings – which we view as a positive. Local-currency Chinese bonds are set to make up roughly 6% of the global fixed income benchmark when the phase-in is complete.”

When yuan-denominated bonds join the Bloomberg Barclays Global Aggregate Index, the Chinese currency would be the fourth-largest currency weight in the index behind the U.S. dollar, euro and yen.

What's Next

Assuming yuan-denominated bonds are included in JPMorgan indexes, LEMB could see an improvement in its credit quality. Currently, about two-thirds of the fund's 216 holdings are rated BBB, BB or B, all below S&P's A+ sovereign credit rating on China.

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