Value In An Emerging Markets Bond ETF

This year has been another miserable one for emerging markets stocks, but some emerging markets bond exchange traded funds have been noticeably less worse. For example, the PowerShares Emerging Markets Sovereign Debt Portfolio PCY is up more than 2 percent year-to-date while the rival iShares JPMorgan USD Emerging Markets Bond ETF EMB is lower by just 1.9 percent.

However, with the WisdomTree Emerging Currency Strategy Fund CEW down more than 10 percent, the story is different for emerging markets bond ETFs denominated in local currencies. The specter of the Federal Reserve increasing interest rates coupled with speculation of additional credit downgrades throughout the developing world, a fate recently suffered by Brazil, are among the issued plaguing local currency bond funds.

Those reasons and others underscore why an ETF such as the WisdomTree Emerging Markets Local Debt Fund ELD is off 14 percent this year. For investors willing to apply the “be greedy when others are fearful” methodology, ELD could actually be offering up opportunity right now.

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WisdomTree Research Director Jeremy Schwartz recently chatted with Chia-Liang Lian, head of emerging markets debt at Western Asset Management, the firm that manages the actively managed ELD in conjunction with WisdomTree.

“Lian noted the Fed’s decision has been supportive of risky assets in EM, with sovereign bonds and local rates remaining firm. Additionally, the Fed’s dovish tilt lent short-term support to the broader EM assets. Looking into the future, the uncertainty surrounding the Fed’s liftoff will likely continue to linger and drive EM price action, but that is only one of a variety of factors the Western team is using to evaluate emerging market opportunities and risks,” said Schwartz in a note out Wednesday.

Though it allocates 9.5 percent of its weight to newly junk-rated Brazil, ELD's credit quality is high as a combined 54.5 percent of the ETF's holdings are rated AAA, AA or A. Another 30.1 percent are rated BBB, which is still investment-grade.

This one way of looking at ratings challenges potentially faced by ELD constituent countries. When adding up Brazil, Russia, South Africa and Turkey, roughly a quarter of ELD's geographic could be vulnerable to a sovereign ratings downgrade. The glass half-full view is that a much larger percentage of the ETF's weight is not at risk to a downgrade.

With emerging currencies now pummeled to the point where traders can argue that most if not all of the bad news is priced in, an ETF such as ELD could be offering value.

“Lian believes that the most appealing segment of emerging market debt today—when evaluating EM sovereign debt in dollars, corporate debt or local currency sovereign market—is the local currency sovereign market,” said Schwartz. “He believes local currencies have become very attractive and potentially mark entry levels today, but he also reminded us to be thoughtful in navigating market cycles and that valuation are not the only consideration.”