ETF expert bets on emerging bonds

by Mark Salzinger, editor The Investors ETF Report

Investors increasingly have favored emerging market sovereign bonds, both for their own attractive attributes and their more positive outlook relative to many developed markets.

Mutual funds and ETFs that invest in emerging market debt have seen growth in assets under management of more than one-third over the past year. Higher yields are part of the attraction; in addition, emerging market also have demonstrated increasing resilience to global economic malaise.

Emerging market also tend to have far lower debt as a percentage of GDP than many developed nations, and many employ countercyclical fiscal policies—that is, they try to spend more into recession to bolster demand and to tuck away surpluses when their economies and tax receipts grow.

iShares JP Morgan US Dollar Emerging Markets Bond (EMB) and PowerShares Emerging Markets Sovereign (PCY) both provide broad exposure to sovereign emerging market bonds. EMB recently held bonds from more than 30 countries, vs. 20 for PCY.

The biggest difference between the two ETFs is that EMB weights its positions accord- ing to the total market value of their debt. This means that countries that issue more debt have heavier weightings.

Thanks to this strategy, Brazil, Russia, Turkey, the Philippines and Indonesia each account for between 6% and 7.5% of the portfolio.

PCY’s portfolio is equal-weighted at each quarterly rebalancing, providing the same exposure to less economically significant countries like Croatia, Hungary, Romania, Lithuania, Qatar and Peru as to Brazil.

This is a boon to PCY when investors’ appetite for riskier emerging market credit is high, and would be expected to hurt when investors are more risk averse.

Since EMB’s inception in early 2008, however, these two ETFs have performed roughly the same. Since the start of 2008, EMB has generated total return of about 55% to PCY’s 53%.

However, over shorter periods, each ETF has enjoyed substantial relative outperformance at times. PCY endured a steeper drop in 2008 (down 19.1% in price and 14.7% net asset value ) than EMB (down 1.9% in price and 11.8% in NAV). Consequently, PCY enjoyed a more robust rebound in 2009, gaining 33.4% in NAV to EMB’s 27.8%.

Between the two, we slightly prefer PCY. It has a lower expense ratio (0.50%, vs. 0.60% for EMB) and a comparable long-term track record. It recently yielded slightly more (4.0%, vs. 3.3% for EMB). And although it has fewer assets ($3.0 billion) than EMB ($6.5 billion), it tends to trades at a narrower bid/ask spread.

However, because that spread can still be substantial, we recommend using a limit order when purchasing shares of either of these ETFs.

Learn more about this financial newsletter at Mark Salzinger's The Investor's ETF Report.

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