EM Bond ETFs Are Still Attractive

If fixed income exchange traded funds are hot, then emerging markets bonds are scorching.

Year-to-date, the iShares J.P. Morgan USD Emerging Markets Bond ETF EMB and the PowerShares Emerging Markets Sovereign Debt Portfolio PCY, the two largest emerging markets bond ETFs trading in New York, are up an average of 15 percent while sporting average annualized volatility of just over 6 percent. That volatility measuring is less than a third of that on the MSCI Emerging Markets Index.

Related Link: The Growth Of Bond ETFs Is Staggering

Investors have been pumping money into the likes of EMB and PCY as part of their yield-hunting endeavors, prompting some speculation of crowded trade or that emerging markets debt isn't as attractively valued as it was earlier this year. Leaving the first point for another day, the valuation concern is worth addressing and investors might like what they hear.

Worth noting is that EMB holds almost an equal amount of investment-grade and junk debt, a unique feature in the world of bond ETFs, and one that means this fund can be measured against investment-grade and high-yield rivals, such as the iShares iBoxx $ Investment Grade Corporate Bond ETF LQD and the SPDR Barclays High Yield Bond ETF JNK.

“After subtracting the fund’s expense ratio of 40 basis points, we arrive at an ALTAR Score™—our forecast of a bond fund’s long-term annualized return to shareholders—of 2.74% (Figure 5). In contrast, the investment grade corporates in LQD offer a much lower yield to maturity of 3.02%, but with an annual default factor of just 15 basis points and an expense ratio of 21 basis points, LQD has an ATLAR Score™ of 2.66%. That’s close enough to the ALTAR Score™ for JNK (a difference of only 8bp) that we can conclude that the market is pricing the relative credit risks of the two fairly efficiently,” said AltaVista Research in a recent note.

EMB's 30-day SEC of 4.47 percent is more than 150 basis points higher than LQD's, but that does not mean investors will pay up for the emerging bond fund.

While EMB doesn’t yield anywhere near what it did back in 2009-10, no fixed income fund does.

"Nonetheless we can see that in the environment of unusually low interest rates that has persisted since around 2012, EMB’s current yields are towards the higher end of their trading range, suggesting that prices are somewhat low,” adds AltaVista.