The Fed Dictates What's Next For These EM Bond ETFs

This data point accurately summarizes the vulnerability of emerging markets debt and equities to anticipated changes in Federal Reserve Policy: To this point in Friday's session, 43 exchange traded funds have hit 52-week lows, 14 of which are emerging markets bond or stock funds.

For those that prefer fractions, about a third of today's 52-week low club is comprised of emerging markets ETFs. Some emerging markets bond funds are particularly vulnerable to higher U.S. interest rates and with the odds dramatically rising this week that the Fed boosts rates at its September meeting, that vulnerability needs to be immediately examined.

Issuers of emerging markets sovereign debt lived off the fat of the land for years. Global investors gobbled up the debt on the basis that many developing countries had lower debt-to-GDP ratios than major developed markets, such as the U.S. Plus, the weak the U.S. dollar made it attractive for emerging issuers to sell dollar-denominated bonds.

With the latter point being true, it stands to reason that ETFs such as the iShares J.P. Morgan USD Emerging Markets Bond ETF EMB and the Vanguard Emerging Markets Government Bond ETF VWOB would not enjoy the idea of a stronger dollar and higher U.S. interest rates. Perhaps surprisingly, investment grade emerging markets debt has performed admirably this week.

“The past week saw a rebound in emerging market sovereigns (+0.17%) while corporates stayed flat. Emerging market sovereign investment grade (+0.25%) outperformed high yield (0.06%), U.S. treasuries (+0.12%), and its U.S. investment-grade counterparts (+0.08%),” according to a Citigroup note posted by Barron's. 

That does not mean the outlook is sanguine. Poland, Turkey and Ukraine bonds are viewed as among the most negatively correlated to changes in Fed policy. Add to that, Turkey could be slapped with a junk credit rating as soon as today. 

The $4.9 billion EMB, the largest emerging markets bond ETF, allocates over nine percent of its combined weight to Turkish and Polish debt. Then there is the matter of Brazil's investment-grade credit rating, a grasp on which can best be described as tenuous. Standard & Poor's recently confirmed it is mulling a downgrade of Brazil's sovereign rating, which at BBB- is the lowest investment grade. 

The iShares MSCI Brazil Capped ETF EWZ hit a multi-year low today. Brazil accounts for 3.4 percent of EMB's weight.

VWOB, the Vanguard emerging markets bond fund, will not be immune to the aforementioned problems. At the end of the second quarter, VWOB allocated a combined 17.6 percent of its weight to Brazilian, Turkish, Polish and Ukraine debt, according to Vanguard data. 

EMB and VWOB are off an average of 3.6 percent over the past 90 days.