The U.S. dollar has been rising and likely will remain strong in the medium term, thanks to a relatively healthier U.S. economy and the expectation that the U.S. will normalize its monetary policy before the eurozone and Japan. In a strong U.S. dollar environment, investors considering emerging-markets bonds to diversify their portfolios may want to focus on funds that invest in U.S. dollar-denominated sovereign debt. While a strong U.S. dollar makes it more expensive for emerging-markets sovereigns to repay their dollar-denominated debt, we note that for the most part, emerging-markets countries have ample foreign reserves. In addition, most emerging-markets countries' U.S. dollar debt is nowhere near levels seen in the mid-1990s--at that time, high levels of U.S. dollar-denominated debt helped contribute to the Asian financial crisis.
Suitability
U.S. dollar-denominated emerging-markets bonds have historically exhibited low correlations to U.S. bonds. This is due to the fact that emerging-markets sovereign bonds carry credit risk, whereas U.S. Treasuries are "risk-free." During the past five years, the correlation between the emerging-markets bond benchmark, the J.P. Morgan Emerging Market Bond Index (J.P. Morgan EMBI), and the Barclays U.S. Aggregate Bond Index has been 0.47.
Both the PowerShares and iShares emerging-markets bond exchange-traded funds hold only U.S.-dollar-denominated bonds. As such, they do not have any direct foreign-currency exposure. Some investors may prefer to invest in local-currency bonds, which can provide better diversification through exposure to local rate trends and foreign currency. This foreign-currency exposure can provide a boost if emerging-markets currencies appreciate against the U.S. dollar, but can be a downer if they slide versus the greenback. Local-currency debt also tends to carry higher credit ratings, relative to hard-currency debt. This is because it can be difficult for countries with weak fundamentals to issue local-currency bonds and as a result tend to issue hard-currency debt.
Relative to U.S. bonds, U.S. dollar-denominated emerging-markets bonds are more volatile, and therefore may not be suitable for those who use their fixed-income allocation as portfolio ballast. During the last three years, the standard deviation of monthly returns for the Barclays U.S. Aggregate Bond Index was 2.8% versus 7.4% for the J.P. Morgan EMBI. Emerging-markets bonds have enjoyed an uptick in interest among foreign investors during the last few years, given issuers' relatively healthy fundamentals and higher yields. As a result, the asset class is now more sensitive to developments in the global macroeconomic environment and fund flows from overseas. A spike in global volatility or deteriorating fundamentals in emerging markets can quickly trigger sudden portfolio outflows. Capital flight will negatively impact the short-term performance of emerging-markets bonds and this ETF.
Fundamental View
Emerging-markets credit profiles have improved significantly during the last 20 years. After the crises of the 1990s in Latin America, Asia, and Russia, many countries implemented sound fiscal and monetary policies and now have average debt/GDP levels that are lower than those within the developed world. Other positive trends include a stable growth outlook, high levels of foreign reserves, greater central bank independence, and flexible currency regimes.
The sovereign debt crisis in Europe and aggressive quantitative easing in the U.S. and other developed nations have led some investors to re-evaluate the creditworthiness of these countries. Many developed nations continue to sport solid credit ratings despite having lofty debt levels and anemic growth.
Meanwhile, many emerging markets still have relatively lower credit ratings despite the fact that they have relatively low debt levels and comparatively better growth prospects. There is growing belief that, despite emerging-markets sovereigns' lower credit ratings, they may actually be better long-term credit risks. So while the funds' average credit ratings are borderline investment-grade, the actual credit risk of these funds' constituents may actually be better than what their ratings suggest.
Thanks to improving fundamentals and relatively higher yields in emerging markets, demand for emerging-markets debt has skyrocketed during the last few years. In the five years leading up to the 2008 financial crisis, flows into U.S.-listed emerging-markets debt funds (which include both mutual funds and ETFs) averaged around $1 billion a year. In 2010 and 2011, this figure jumped to $15 billion a year, followed by a record $28 billion in 2012. Strong growth in supply (new bond issuance) and demand (rising allocations) are positive long-term trends for emerging-markets issuers. However, the downside to these trends is that emerging-markets bonds are now more susceptible to global sentiment. In 2013, concerns about the impact of the tapering of the U.S. Federal Reserve's asset-purchase program on the emerging markets resulted in a flare-up in volatility and average declines of 7% across emerging-markets bond funds in 2013.
