Local Currency Emerging-Markets Bonds: High Yields and Low Interest-Rate Risk

WisdomTree Emerging Markets Local Debt ELD is one of the first funds to give investors access to local-currency emerging-markets bonds. With all the concerns about rising debt in the developed markets, investors are increasingly looking to emerging countries for their high growth rates and low comparative debt levels. Emerging markets have traditionally relied on developed countries for demand and financing, but those dynamics have shifted during the past 12 years. Furthermore, an emerging middle class has been creating strong domestic economic growth in these countries, which should bolster a healthy and sustainable rise in sovereign wealth. This has allowed emerging countries to maintain sound fiscal policies, more-flexible currencies, a higher savings rate, and a growing private pension system.

We like this fundamental story, but we are also aware of the tremendous amount of assets that have been flowing into this sector in the last year. This has the potential to also create an overvalued asset class as investors continue to flock to income investments.

Suitability
ELD is a satellite holding for investors for investors willing to accept the heightened risks of foreign fixed-income securities. The exchange-traded fund tracks a portfolio of local currency emerging-markets government bonds from 15 different countries with an average credit rating of BBB. In fact, more than 80% of the bonds in ELD are investment-grade.

Emerging markets have increased political and economic risks that make them more susceptible to default. Many emerging markets do not have strong democratic governments and have been willing in the past to default on their debts at the first sign of trouble. This attitude is changing as they integrate more fully in the global economy. On a fiscal level, emerging countries have actually been reducing their debt levels consistently over the past 10 years. With the sovereign debt crisis in Europe, investors are re-evaluating which countries are most creditworthy. The developed world has good credit ratings and very high debt levels. The emerging world has lower credit ratings and low debt levels. There is growing belief that, despite emerging markets' lower credit ratings, they may actually be better credit risks.

As with any fixed-income product, investors need to be mindful of the risk of rising interest rates. With a duration of only 4.4 years and an above-average yield to maturity of 5.2%, investors are reasonably insulated from this future threat. For comparison, a similar maturity Treasury bond yields only 0.7%. A low-yielding Treasury bond is more susceptible to losses in a rising interest-rate environment than is a higher-yielding security. With that said, high unemployment will probably delay the Federal Reserve from meaningfully raising interest rates until 2015 at the earliest.

ELD owns local currency bonds, so investors need to be prepared to weather higher volatility than with a traditional U.S.-only bond fund. Foreign-currency movements will affect the value of the fund dramatically. In the past year, ELD had a standard deviation of 16%, which is dramatically higher than the 3%-5% of a typical U.S. bond fund. If the emerging markets continue growing their economy faster than the United States does, their currency should rise versus the dollar, which will be positive for ELD over the long term. In the short term, a crisis can cause a flight to the safety of the U.S. dollar, which can cause short-term losses for the bonds in ELD.

In the past few years, emerging-markets equities and bonds have become a larger portion of investors' portfolios. In the past year, the emerging-markets debt category has grown by $24 billion which is a 36% increase in assets in the category. This demand is because of stronger economic growth in emerging markets compared with meager growth from the developed world. This is tremendous increase in assets for such a small portion of the fixed-income market, but according to WisdomTree, the size of the emerging-debt market is $1.3 trillion, so while the fund inflows have been impressive, there is not a concern yet that the market is saturated.

Portfolio Construction
The fund is actively managed and does not follow an index. The fund invests in sovereign bonds in as many as 15 emerging-markets countries. The current duration is 4.4 years, but the managers intend to maintain a duration between 2.0 and 7.0 years.

ELD implements a tiering strategy that attempts to put more assets in countries that maintain strong fiscal discipline. There are four countries in tier one, each getting an 10.3% weighting; six countries in tier two, each getting a 6.9% weighting, and five countries in tier three, each getting a 3.5% weighting. The countries currently in tier one are Indonesia, Brazil, Mexico, and Malaysia. This strategy should increase the average credit quality of the fund because more assets will go into the highest-quality countries.

Fees
This fund levies a 0.55% expense ratio, which is on par with other funds in the category. With more than $1 billion in assets and trading volumes of more than 200,000 shares per day, ELD is one of the most liquid foreign bond ETFs available.

Alternatives
The closest alternative is Market Vectors Emerging Market Local Currency Bond ETF EMLC, which is a passively managed fund with expenses of 0.49%. Investors looking for only U.S.-dollar-denominated bonds should consider iShares JPMorgan USD Emerging Markets Bond EMB or PowerShares Emerging Markets Sovereign Debt PCY, which charge 0.60% and 0.50%, respectively.