Another Catalyst For EM Bond ETFs

Exchange-traded funds holding emerging market bonds, including the iShares JPMorgan USD Emer Mkt Bnd Fd ETF EMB, have had the wind at their backs this year, as the Federal Reserve has held off on raising interest rates, suppressing the dollar in the process.

Contextual Backdrop

The case for the dollar-denominated debt held by EMB and rival ETFs is bolstered in the a “lower for longer” environment, because emerging market bonds denominated in dollars have previously proven sensitive to rising Treasury yields.

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Importantly, there are other factors at play bolstering the case for emerging market bond ETFs that extend beyond tempting yields and the Fed not raising rates. While ETFs such as EMB are often beholden to external factors such as Fed policy and dollar strength, improving domestic fundamentals in some developing economies help matters.

Economic Growth And EMB, Peers

“Emerging market economic growth managed to hang on to much of its momentum over August according to the latest release of the IHS Markit Emerging Market Composite PMI index. The August reading indicated that emerging market economies stayed in expansion territory for the third month in a row for the first time since the spring of last year,” said Markit in a recent note.

“Growth in developed economies, while still in expansion territory, continued to be challenged with the current pace of expansion materially lower than the pace seen at the turn of the year.”

Some of EMB's largest country allocations, including the Philippines and Indonesia, show expanding economies. Russia, on the other hand, as the ETF's third-largest geographic weight, is working its way out of its worst post-Soviet era recession.

The rush to emerging markets bonds have the asset class sporting equity-like returns this year. Year-to-date, EMB is up 15.3 percent, which trails the MSCI Emerging Markets Index by 230 basis points, but the bond ETF has been only a quarter a volatile as the widely followed developing world equity benchmark.

Yield

Of course, yield is also motivating investors to embrace ETFs like EMB. EMB has a 30-day SEC yield of 4.38 percent, far superior to what investors will find on most developed world sovereigns. That likely explains why EMB has added $4.3 billion in new assets this year, a total exceeded by just two other fixed income ETFs.

“Strong returns delivered by sovereign EM bonds has knocked over 110bps off the asset class’ yield ytd, which is nearly twice the tightening seen by US Treasuries bonds over the same period of time. These plunging yields mean that US investors are now receiving 2.9 percent of extra yield by parking their money in dollar denominated EM sovereigns, which is roughly 20bps less than the average extra yield delivered by the trade in the six years since the Markit iBoxx USD Emerging Markets Sovereigns launched in 2010,” added Markit.

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