With the U.S. Treasury bonds now at ultra-low yield levels, the investors are looking at alternate sources of income from their investment portfolios. One asset class which has attracted a lot of investors' interest recently is emerging markets debt, as it provides an opportunity to earn much higher yields with capital appreciation, while adding diversification benefits to the portfolio.
As a result of growing interest in this asset class, there are currently many ETFs available that provide exposure to different classes of debt issued in emerging markets. (Read: Forget T-Bonds, Invest in These Top Corporate Bond ETFs )
The investors can choose between the debt issued by the governments or the corporates or between debt issued in US Dollars or in local currencies.
The case of investing in emerging markets sovereign debt seems to be pretty strong now. Many emerging countries now have better fiscal health and lower debt levels than their developed counterparts. Healthy emerging economies also have adequate levels of foreign exchange reserves and deep and liquid financial markets. Thus the chances of sovereign default are extremely low.
Further, while interest rates are at rock-bottom levels in the U.S. and can only go up from the current levels, the rates in emerging countries are still high. The central banks in many of these countries were raising rates till last year but reversed the monetary cycle later last year or earlier this year, as the growth slowed and inflation came within their acceptable range.
With inflation reigned in, these central banks now have more flexibility to cut rates further, in order to support growth. As the fixed income instruments appreciate when the interest rates go down, the investors investing in the emerging markets sovereign debt have better chances of capital appreciation. (Read: Three Excellent Dividend ETFs for Safety and Income )
We may add that in general, emerging market currencies are more volatile than the U.S. Dollar and in times of global economic turmoil, the Dollar benefits from its "safe haven" status.
However, in the longer-term, the currencies of healthy developing economies are likely to outperform the Dollar.
For investors who do not want short-term currency related fluctuations in their portfolio, US dollar denominated bond ETFs like J . P. Morgan USD Emerging Markets Bond Fund ( EMB ) and PowerShares Emerging Markets Sovereign Debt Portfolio ( PCY )are the better options. Please read: Top Two Emerging Market USD Bond ETFs Head-to-Head ) on these ETFs.
However, investors looking for true diversification in their portfolios and higher longer-term return should consider investing in emerging markets local currency bond ETFs.
In addition to greater return potential in the long-term, these ETFs are less sensitive to interest rate changes compared with USD denominated debt ETFs due to their shorter duration (4-5 years) compared with the duration of two USD denominated emerging market debt ETFs (7-9 years).
Below we have analyzed four ETFs that invest in the debt issued by the emerging markets governments in their local currencies. (Read: Can You Beat These High Dividend ETFs?)
WisdomTree Emerging Markets Local Debt Fund ( ELD )
ELD does not track a specific benchmark, but seeks a high level of total return consisting of both income and capital appreciation by investing in emerging market local debt. Currently 83.1% of the assets are invested in sovereign bonds and 14.3% in supranational bonds.
The fund has more than $1.2 billion in AUM as of now. The fund has 90 holdings with average years to maturity of 5.1 years and an effective duration of 4.4 years. Current SEC yield is 4.27% while the expense ratio is 55 basis points per annum.
Mexico (10.6%), Indonesia (10.3%), Malaysia (10.2%) and Brazil (10.0%) are the top countries in terms of exposure. About 78% of the bonds are rated BBB or higher (investment grade rating). ELD has returned 6.3% year-to-date.
Market Vectors EM Local Currency Bond ETF ( EMLC )
EMLC tracks JP Morgan GBI-EMG Core Index that provides direct exposure to local currency bonds issued by emerging market governments. The fund pays out dividends on a monthly basis and capital gains annually. The fund holds 184 securities, with an average modified duration of 5.0 years and average years to maturity of 7.5 years.
In terms of country exposure, Poland (10.1%), Malaysia (9.6%), South Africa (9.3%) and Brazil (9.0%) occupy the top spots. The fund was launched in July 2010 and now has $746.9 million in AUM.
The ETF charges expense ratio of 49 basis points, while the 30 day SEC yield is 5.4% currently. 54.1% of the index holdings are rated investment grade by S&P. EMLC has returned 8.6% year-to-date.
SPDR Barclays Capital Emerging Markets Local Bond ETF ( EBND )
EBND tracks Barclays Capital EM Local Currency Government Diversified Index, which is designed to measure the performance of fixed rate local currency sovereign debt of emerging market countries, having remaining maturity of one year or more and rated B- or higher. 30 days SEC yield is 4.94% currently.
Average maturity of its 234 holdings is 6.6 years, while the modified adjusted duration is 4.8 years. South Korea (12.3%) and Brazil (12.1%) followed by Mexico (8.7%) and Poland (6.2%). EBND has returned 7.0% in 2012.
iShares Emerging Markets Local Currency Bond Fund ( LEMB )
LEMB tracks the Barclays Emerging Markets Broad Local Currency Bond Index, which is designed to track emerging market sovereign debt, issued in local currencies.
The fund which made its debut in October 2011 has attracted AUM of $50.5 million so far, invested in 47 holdings. The expense ratio is 60 basis points while the 30 days SEC yield is 4.62% currently. The credit rating is BBB- per S&P Ratings.
South Korea (22%), Brazil (13%) and Mexico (8%) occupy the top spots in terms of country exposure. The ETF has gone up 2.5% year-to-date.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.