EM Bond ETFs: Trouble Ahead? (LEMB, IHY, HYXU)

There's no doubt the pace of new emerging markets bond ETF introductions has been impressive in 2012. Since the start of April alone, iShares, the world's ETF issuer, has introduced four international bond funds. Van Eck Global, the fifth-largest U.S. ETF firm and parent company of Market Vectors, has rolled out two global bond ETFs in the last month to go along with several previously existing that focused on non-U.S. bond markets. While investors have shown a willingness to pour cash into emerging markets bonds funds, the WisdomTree Emerging Markets Corporate Bond Fund EMCB has $60.5 million in AUM in just two months of trading and that's just one example, their hunt for global yield might be overlooking one critical factor: Emerging markets default rates. Default rates are a factor to consider when investing in any number of bond funds, but the risk obviously rises in the high-yield universe and some investors might be prone to believe default rates escalate in emerging markets as well. Market Vectors high-yield debt portfolio manager Fran Rodilosso said default rates rose in the first quarter, but added credit metrics across regions and sectors remain stable. "Although, in my opinion, we may be closer to the top of the credit cycle than the bottom," Rodilosso said in a statement. "Balance sheets for issuers in emerging markets are still relatively healthy and liquidity is still readily available. Of course, some companies are to be avoided due to balance sheet and management issues, but we see no indication that systemic issues caused rising default rates." Granted, Rodilosso has some skin in the game as he manages the newly minted Market Vectors Fallen Angel High Yield Bond ETF ANGL and the Market Vectors International High Yield Bond ETF IHY. ANGL is more domestic in scope, but IHY is purely global and features a 33% allocation to emerging markets bonds. Since its debut on April 3, IHY has raked in $20 million in AUM. IHY debuted on the same day as the iShares Global ex USD High Yield Corporate Bond Fund HYXU and the iShares Emerging Markets High Yield Bond Fund EMHY. HYXU has attracted almost $25 million in AUM while investors have poured more than $10 million into EMHY. Rodilosso isn't alone in his view that emerging markets bonds are still a generally healthy asset class. Earlier this week, Russ Koesterich, iShares Global Chief Investment Strategist, reiterated his view that income investors should consider emerging markets bonds for their fixed income portfolios. In a note published on the iShares blog, Koesterich wrote "...emerging markets exited the financial crisis in a far better position than their developed market counterparts. The average debt burden of emerging markets is less than 40% of gross domestic product, while developed market debt has soared to more than 100% of GDP on average." Even though corporate and sovereign balance sheets in the emerging world are mostly health and several marquee developing markets could see their credit ratings lifted in the near-term, Colombia and Indonesia come to mind as potential candidates, investors appear to be focused on yield. Who could blame them? IHY could yield over 8% and pay a monthly dividend. The WisdomTree Emerging Markets Corporate Bond Fund has a 30-day SEC yield north of 4.7%. The iShares Emerging Markets Local Currency Bond Fund LEMB has a distribution yield of 4.7%. Those yields are all vastly superior to what an investor would get with a Treasuries ETF or the iShares iBoxx $ Investment Grade Corporate Bond Fund LQD. For more on bond ETFs, please click HERE.