Finally, Some Hope For EM Bond ETFs

Exchange traded funds holding emerging markets bonds, both the dollar-denominated and local currency varieties, were among 2012's most popular bond funds.

A spate of interest rate reductions by developing world central banks and the Federal Reserve's own easing efforts helped bolster the fortunes of ETFs such as the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) and the PowerShares Emerging Markets Sovereign Debt Portfolio (PCY).

This year has brought a nasty, 180-degree reversal of fortune for developing world debt due to plunging currencies and fears about an end to the Federal Reserve's quantitative easing program, but for believers of "when there is blood in the streets"investing, emerging markets bond ETFs may hold some rebound potential.

"In the three months ending in July, local currency-denominated EM sovereign bonds fell 10.6%, U.S. dollar-denominated EM sovereign bonds declined 7.8%, and U.S. dollar-denominated EM corporate bonds dropped 5.8%., according to a research note published by PIMCO, the world's largest bond manager.

EMB and PCY, home to almost $6 billion in assets under management combined, are dollar-denominated ETFs. Well-known local currency emerging markets bond ETFs include the Market Vectors Emerging Markets Local Currency Bond ETF (EMLC) and the WisdomTree Emerging Markets Local Debt Fund (ELD), the first actively managed ETF to reach $1 billion in assets.

Ramin Toloui, PIMCO's global co-head of emerging markets portfolio management, said history suggests emerging markets bond sell-offs can offer "attractive buying opportunities."

"The past would suggest that periods of underperformance in EM ultimately could become buying opportunities. Over the past 10 years, quarters in which total returns were negative were followed by quarters of positive returns more than 70% of the time in local currency- and U.S. dollar-denominated EM bonds. This implies that in the past a certain amount of mean reversion has been the norm, in which selling during periods of stress overshoots and is followed by a bounce in prices after the stress subsides," said Toloui in the note.

Toloui notes that the emerging markets bond sell-off has forced yield curves to embed expectations of future interest rate increases. Central banks in Brazil, Indonesia and Turkey have recently boosted rates to prop up sagging currencies and stem capital outflows.

Citing HSBC data, PIMCO notes markets are expecting another 262 basis points in interest rate hikes out of Brazil, 178 basis points in increases from Indonesia and nearly 90 basis points to be tacked on to Turkey's lending rate. Those three countries combine for about 18 percent of EMB's weight. ELD, the local currency fund, allocates over 27 percent of its weight to those nations.

The retrenchment in emerging markets bonds prices means yields have risen and although yields on 10-year U.S. government bonds reside around 2.7 percent, Toloui notes "a Brazilian 10-year government bond that (as of 13 August) yielded 11.43% in local currency terms would have locked in an annual yield differential of 871 basis points (bps) versus a 2.72% yielding 10-year U.S. Treasury, if held to maturity."

Investors looking to take advantage of attractive valuations in emerging markets bonds should take a pass on fundamentally weak nations, such as those plagued by wide current account deficits and those that could see credit downgrades. India fits the bill on both fronts.

Mexican bonds, an asset class previously endorsed by PIMCO's Bill Gross come with the benefit of a strong balance sheet.

Mexican 10-years yield about 110 basis points more than the comparable U.S. bonds, according to Bloomberg data. ELD features a 10.5 percent weight Mexican peso bonds while EMB has a 6.3 percent weight to dollar-denominated Mexican bonds.

BY Todd Shriber, ETF Professor