The Right Way To Embrace Emerging Market Bonds

Amid Brazil's descent to junk status, speculation Latin America's largest economy will be subject to more sovereign credit downgrades and talk that other emerging markets will fall victim to the same scenario, some exchange traded funds holding developing world debt have been relatively sturdy this year compared to their equity-based counterparts.

However, not all emerging markets bond funds are created equal and with scores of economies in the developing world supposedly vulnerable to changes in U.S. interest rates, now is the time for investors considering these ETFs to be ultra-selective.

The actively managed WisdomTree Emerging Markets Local Debt Fund ELD is one place to start for investors mulling emerging markets debt. Though active management's shortcomings, both with fixed income and equities are well-documented, ELD has some points in its favor.

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Notably, the ETF features no exposure to Nigerian debt nor did ELD hold Nigerian bonds earlier this month when JPMorgan Chase said it would remove Africa's largest economy from its local-currency emerging market bond indexes. More than $200 billion tracks those benchmarks.

“Instead, ELD’s approach focuses on fiscal sustainability and external vulnerability indicators in order to monitor risk. Political risk and economic solvency are also considered. The process allocates weight according to three tiers, where the country exposures within each respective tier are equally weighted. The portfolio is rebalanced to targeted exposures on a quarterly basis, and the currency selection and universe definition are reassessed at scheduled intervals at least annually. The result? Troubled countries like Nigeria often don’t make the cut,” according to a new research note from WisdomTree.

In the essence of fairness, it should be noted that ELD hit an all-time low Monday and the ETF has an almost 9.6 percent weight to now junk-rated Brazil.

On the other side of the fairness spectrum, ELD allocates just over 7 percent of its weight to stable, highly-rated South Korean won-denominated bonds, a trait not featured by two of the widely followed JPMorgan emerging markets bond indexes. Additionally, ELD is underweight Indonesian, South African and Turkish bonds relative to those JPMorgan indexes. That is an important factor when considering those countries are seen as highly vulnerable to changes in U.S. interest rates and have been highlighted as the next in line to potentially draw the ire of ratings agencies.

“It is noticeable that South Korea is a middle-tier exposure, but has no representation within the Indexes shown. Similarly, China and India are third-tier exposures with no representation in the J.P. Morgan Indexes. This is an important point—ELD’s active process is not tied to the actions taken by other Indexes,” according to WisdomTree.

Though India and China are not risk-free at the moment, their debt ratings are not at risk of downgrades. The two countries combine for nearly 7 percent of ELD's weight. Nearly three-quarters of ELD's holdings are rated AAA, A, BBB. The ETF has a 30-day SEC yield of 5.74 percent.