Investors Renew Enthusiasm For Emerging Market Bond ETFs

The Federal Reserve raised interest rates for the first time in 2017 last week and expectations are in place for a couple of more rate hikes before the end of this year.

In theory, the specter of higher U.S. interest rates should dampen investors' enthusiasm for rate-sensitive, income-generating assets such as emerging markets debt. Reality is showing a different trend, as investors are putting money to work with exchange traded funds such as the iShares J.P. Morgan USD Emerging Markets Bond ETF EMB.

“Emerging market bonds have regained favor with investors in 2017 and are on track to register the second largest quarterly inflow on record,” said Markit in a recent note. “The closing three months of last year had seen investors’ faith in the asset class waiver due to US interest rate normalization and growing uncertainty stemming from the incoming administration’s 'America First' agenda which saw over $2 billion flow out of emerging market bonds.”

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

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.

The $9.55 billion EMB, which holds 351 bonds, has a 30-day SEC yield of 4.76 percent and an effective duration of 6.83 years. Investors have added $1.41 billion to EMB year-to-date. EMB's primary rival, the PowerShares Emerging Markets Sovereign Debt Portfolio PCY, has added $133 million in new assets this year. Only 10 PowerShares ETFs have seen larger year-to-date inflows.

PCY has a 30-day SEC yield of 5.25 percent and an effective duration of 8.87 years. EMB and PCY have been key drivers of flows to emerging markets debt ETFs this year.

“The hefty $5 billion of new assets that has flowed into emerging market bond ETFs this year to date indicates that the gathering economic momentum is overriding any lingering fears around policy uncertainty,” said Markit. “This growing consensus is also reflected by the fact that investors are now willing to receive much less yield to hold dollar denominated emerging market bonds over US treasuries than at any point over the last year.”