Of The Fed And Emerging Markets Bonds ETFs

Emerging markets sovereign debt and the corresponding exchange-traded funds are viewed as vulnerable to hawkish changes in U.S. interest rates. With the Federal Reserve perhaps nearing a rate hike sometime over the next two months, some market observers are betting this time will be different for emerging markets bonds.

The $3.17 billion PowerShares Emerging Markets Sovereign Debt Portfolio PCY, which tracks a basket of dollar-denominated developing world debt, has recouped all of its losses experienced following the release of the May Federal Open Market Committee (FOMC) meeting minutes and is up 1 percent over the past month.

Weaker Dollar, Rebounding Commodities And Debt

Although emerging markets currencies are on the mend this year, thanks in large part to the weaker dollar and rebounding commodities prices, ETFs holding emerging markets debt denominated in local currencies can deliver solid returns, while also exposing investors to elevated volatility.

Related Link: Expect Higher Profits For This ETF's Holdings

“Note that dollar-denominated emerging market bonds are more closely correlated to US investment grade bonds than to US equities. This is not the case for local currency emerging market debt, which may reduce its diversification benefits,” said PowerShares in a recent note. “In addition, dollar-denominated emerging market bonds have historically provided better risk-adjusted returns over long periods of time than emerging market debt denominated in local currency.”

PCY has a duration of 8.62 years, so there is some sensitivity to interest rates with this ETF. Investors are compensated for that rate risk with a 30-day SEC yield of nearly 5.4 percent. Credit risk is also a concern of investors mulling stakes in ETFs such as PCY, so it must be pointed out that the 40 percent of the ETF's lineup is rated either BB or B.

Interest Rate Sensitivity

Emerging markets bonds' sensitivity to interest rates is easy to figure out. Emerging markets governments and some corporations binge borrowed in dollars during the various versions of the Fed's quantitative easing programs. It looked smart as the dollar weakened against a plethora of developed and emerging currencies, but those emerging markets borrowers were caught off guard when the dollar started soaring several years ago.

“Over the course of nearly eight years, dollar-denominated emerging market debt generated higher return per unit of risk than US investment grade bonds, large-cap US equities and emerging market bonds denominated in local currency,” according to PowerShares. “And this outperformance wasn’t merely a function of dollar strength. Between Jan. 31, 2009, and Aug. 31, 2011, the US dollar fell in value by 7.5 percent. Despite that tailwind for overseas currencies, traditional local currency bonds still generated poor risk-adjusted returns.”