There's Still Opportunity In EM Bond ETFs

Emerging markets bond exchange traded funds spent considerable time as one of 2016's hottest asset classes, a status aided by a sanguine outlook for U.S. interest rates and a lethargic dollar. Those scenarios changed later in the year as the Federal Reserve boosted interest rates in December.

With many market observers betting the dollar will remain sturdy this year and that the Fed could possible hike rates multiple times, a case can be made that emerging markets debt ETFs face headwinds. Dollar strength is believed to be a potentially thorny issue for ETFs such as the VanEck Vectors J.P. Morgan EM Local Currency Bond ETF EMLC, which holds debt denominated in local currencies.

To its credit, EMLC has dealt with tricky environment to start 2017 with a gain of more than 2 percent. EMLC has an effective duration of less than 4.9 years, putting it in the middle part of the curve, so the fund is not intensely vulnerable to hawkish changes in U.S. monetary policy. 

“Despite significant weakness in local currencies in November, local currency bonds returned 1.9% for the month and 9.9% for the year. Brazil, Russia, and South Africa were the strongest contributors for the year with significant gains from both local rates and currencies, while the segment overall attributed almost all of its return to rates,” said VanEck in a recent note.

Mexican debt and the peso were punished in the wake of Donald Trump's win the November U.S. presidential election while the Turkish lira has come under pressure due to political volatility there. Mexico is EMLC's second-larges geographic weight at 8.8 percent behind Poland, but the ETF devotes than 6 percent of its weight to Turkish bonds.

Mexico has been a drag on the ETF in the wake of Trump's win because of his harsh rhetoric aimed at Mexico. Not to mention the peso has been a laggard among emerging currencies last year. On the upside, Mexico carries an investment-grade rating and is historically not as volatile as other emerging economies.

“However, we believe that the different segments of emerging markets bonds provide opportunities in 2017. From a valuation standpoint, yields and spreads on local and hard currency sovereign bonds, respectively, are above five-year averages. Given recent outflows, which moderated in December, technicals do not appear unfavorable. More importantly, economic growth and external positions continue to improve and there are signs of fiscal discipline and structural reforms, particularly in Latin America,” adds VanEck.

The $2.6 billion EMLC carries a 30-day SEC yield of 5.92 percent.