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Comparing Your Emerging-Markets Bond ETF Options

Should you buy local-currency or U.S.-dollar bonds?

Timothy Stauts, 11/23/2011

In the past decade investors have embraced international-stock investing, but many of those same people still own all their fixed income in U.S. bonds. When interest rates were higher you did not need to take on the additional risk of international investing. But today, with ultralow interest rates and concerns about the credit quality of the U.S. government and corporations, it may make sense to look to emerging markets for new opportunities.

Emerging-markets debt historically has been very volatile and prone to defaults. Russia defaulted on its debt back in 1998, and both Brazil and Argentina delivered major headaches to investors shortly after the turn of the century. Today, however, the tables have turned. Most pundits are now more worried about developed-world economies, especially in Europe, than those of emerging economies. Many emerging markets have improved their financial stability by abandoning fixed exchange rates, adopting inflation targeting, reducing external debt, and lowering fiscal deficits. By following these sound fiscal and monetary policies, the average debt/gross domestic product ratio of emerging-market countries is less than 50% while the United States' ratio is closer to 100%. As a result there is growing belief that, despite emerging markets' lower credit ratings, they may actually be better credit risks than many developed markets are.

If you can endure the risks and are considering investing in emerging-markets bonds, the first thing you need to decide is whether to buy U.S.-dollar-denominated or local-currency bonds. Most debt was issued in U.S. dollars until recently because investors refused to take the risk of currency exposure to these emerging countries. This created a problem for emerging countries if their currency devalued versus the dollar, which made debt payments much more expensive. As a result, in the past few years emerging countries have worked to reduce their reliance on external funding and the risks of issuing U.S.-dollar debt. They have developed local bond markets that recently have begun to offer longer-maturity securities as demand has increased.

The liquidity in the local markets is adequate but not yet as liquid as the U.S.-dollar emerging bond market. The lower liquidity levels and fluctuating exchange rates make local-currency bonds more volatile than their U.S.-dollar-denominated counterparts. On the other hand, local-currency bonds act as a hedge on further U.S.-dollar weakness. If emerging markets continue growing their economies faster than does the United States, their currency could rise versus the dollar, which will be another source of positive returns for local-currency bonds. The flip side, of course, is that these currency fluctuations could lead to substantially higher volatility.

An investor looking for higher yields than comparable U.S. offerings and moderate risk should look to the U.S.-dollar emerging-market bond exchange-traded funds. For enhanced diversification, higher risk, and greater potential long-term returns, local-currency emerging-markets bonds are the answer.

Let's review the current ETF investment options in the emerging-markets bond space.

Powershares Emerging Markets Sovereign Debt PCY
PCY is a U.S.-dollar-denominated fund that employs an equal-weight strategy, so all countries have about the same weight in the index. The fund currently invests in 22 countries and owns about three bonds from each country. This very broad diversification minimizes the risk of any one country defaulting on its debt. PCY's portfolio has an average maturity of 14.7 years, which is the longest-term portfolio in the category. The fund's increased interest-rate risk hasn't hurt returns yet because rates have been declining globally for the past few years. IShares Barclays 10-20 Year Treasury Bond TLH holds a portfolio of U.S. Treasury bonds and has a similar average maturity to PCY but only has a yield to maturity of 2.48%. PCY yields 5.79% which gives PCY a 3.31% advantage in terms of yield. In this low-interest-rate environment there are definitely increased risks with emerging markets but you're getting paid quite well to take those risks.

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