Why Emerging Market Bond ETFs Are Safer Than Developed Markets

by on May 28, 2010 | ETFs Mentioned:

Recent economic turmoil has shaken markets around the world as the odds of a sovereign debt crisis in Europe creep gradually higher. The debt-laden nations of Greece and Spain have seen the prices of their bonds plummet as investors demand additional compensation for higher perceived risk; the yield on Spanish debt has nearly doubled in a month on short-term debt, demonstrating just how fearful investors have become. However, this issue has impacted more than just the fiscal weaklings, hammering bond markets throughout the euro zone.

As a result, many European debt markets have seen bond yields shoot higher as investors flee to the relative safety of the U.S. dollar and scoop up debt of relatively stable European economies; Germany recently saw its yield slide so low that the government was forced to retain 1.1 billion euros worth of bond supply due to a lack of demand.

As the euro has plummeted against major rivals, currency exposure in fixed income securities has become an important consideration. Generally, the ETFs in the International Government Bond ETFdb Category are denominated in local currencies such as the euro or pound, most of which have seen huge drops over the past month. This currency risk has pushed international investors further away from these international bonds that have weakened as the dollar has strengthened. On the other hand, all of the ETFs in the Emerging Market Bond ETFdb Category consist of debt securities that are denominated in dollars, and therefore offer a very different risk profile in the current environment. These factors have contributed to a widening return gap between emerging and developed market bond ETFs as investors have been forced to reevaluate the relative risk inherent in these investments.

Below we highlight four ETFs, including two developed market bond funds and two emerging market bond funds, in order to illustrate the difference between the recent performance of these two types of securities.

SPDR Barclays Capital Short Term International Treasury Bond ETF (BWZ)

BWZ offers investors a wide range of countries with just under one-quarter allocated towards Japanese debt. Italy, at about 12%, makes up the second highest allocation with Germany close behind at 12.3%. Additionally, South Korea, a country which has been rocked as of late due to geopolitical concerns, makes up 6% of the bond and has helped to contribute to the fund’s poor performance as of late. BWZ is down almost 5% over the past four weeks and nearly 8% thus far in 2010 (see BWZ’s holdings page).

iShares S&P/Citi 1-3 Year International Treasury Bond Fund (ISHG)

ISHG tracks the Barclays Capital 1-3 Year Global Treasury ex-US Capped Index, a benchmark that measures the performance of fixed-rate local currency sovereign debt of investment grade countries outside the United States that have remaining maturities of one to three years. The fund has a heavy focus on Japanese debt, which makes up nearly 25% of the total assets. Other large allocations include Germany (10.9%) and the hard hit nation of Italy at 7.7%. This large allocation towards Italian bonds, as well as a 5% allocation towards Greek bonds, is a large reason for this fund’s lackluster performance in 2010. It is down 4.5% over the past month and more than 9% since the beginning of the year.

PowerShares Emerging Markets Sovereign Debt Fund (PCY)

PCY tracks the DB Emerging Market USD Liquid Balanced Index, a benchmark that follows the potential returns of a theoretical portfolio of liquid emerging markets U.S. dollar-denominated government bonds issued by approximately 22 emerging-market countries. Among the largest holdings are Uruguay (4.4%), Russia (4.4%), and Indonesia (4.4%). In addition to offering much higher yields than their developed market counterparts (Indonesian bonds for example are yielding 8.5%), this fund maintains minimal exposure to the euro zone. Although the fund is down about 2% over the past month, it is in positive territory in 2010, and pays a handsome dividend yield of close to 6.1% (see the Definitive Guide To Emerging Market Bond Investing).

iShares JP Morgan Emerging Bond Fund (EMB)

EMB’s top holdings include Russia (9.1%), Philippines (4.4%), and Turkey (4.3%). Much like PCY, this fund it tilted away from Europe and has thus avoided many of the sovereign debt issues that are currently plaguing the continent. EMB is slightly less concentrated than PCY in its top holdings, and maintains roughly 15 more components than its counterpart. EMB is also down slightly over the last month but up on the year, putting it well ahead of the developed market funds profiled above (see Emerging Market Bond ETFs Head-To-Head).

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Disclosure: Eric long PCY