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By Jeremy Glaser and Timothy Strauts | 11-06-2012 11:00 AM

Are Emerging-Markets Bonds Overheating?

Flows have been high into developing-markets debt ETFs as investors seek more yield, but several funds are apt to manage the credit risks.

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. Low yields in the United States have had many investors turning to emerging markets looking for extra income. I am here with Tim Strauts to look at that strategy and see what exchange-traded funds are best to execute it.

Tim, thanks for joining me.

Tim Strauts: Glad to be here.

Glaser: So, let’s talk a little bit about why investors are all of sudden it seems interested in emerging-markets debt? What’s the appeal?

Strauts: This is not a new story, but the basic premise is the idea that the emerging world has very low debt/GDP ratios, their economies have very low debt levels in relation to their GDP, and their GDP growth rates are much higher than developed world. So, if you are looking at who is the better credit risk, a country with low debts and high growth rates or a country like the U.S. or some of the countries in Europe with very high debt rates and very low GDP growth. Well, it’s obvious you will then chose emerging world. So that’s really the main story.

Now, the reason that there have still been higher yields and you still can get higher yields in the emerging world versus say very low yields in the U.S. and Europe, is that there is still risk of default because some of these governments are not as stable as the developed world, so that risk is still out there. But in general they are very good credit risks right now.

Glaser: One of the big questions people have is about currency. What are some of the things people should keep in mind in terms of currency risk when investing in these funds, as well?

Strauts: Well, there are two different types of emerging-markets bonds. There is the U.S. dollar-type bond and local currency. And the reason there are two types is because when say 20 years ago when an emerging country was trying to issue debt, its currency was so volatile that it couldn’t attract investors from the U.S. and Europe if it didn’t denominate the bonds in that country’s local currency. So there is a very strong market for U.S.-dollar emerging-markets bonds. So if you invest in that type of bond, you don’t have the currency risk. There is no currency fluctuation. You just get the yield and the payments just like a regular bond.

Now, with a local currency bond, which has really been developed in the last say five to seven years, you get the yield of the bond plus the currency movements. Now, that can be positive or negative, and it makes the bonds much more volatile. But over the long term we would say that since the emerging world has higher GDP growth rates that you’d expect their currencies to rise versus the U.S. dollar. So, over the long term, we think the currency play of local-currency bonds is actually net positive, but if there is a global recession or things like that, it can a very strong negative in any one year.

Glaser: So of the big emerging-markets debt exchange-traded funds, which ones are in local currency and which ones are in dollar-dominated bonds?

Strauts: There is a pick we have in each category. For U.S.-dollar bonds we'd recommend the PowerShares Emerging Markets Sovereign Debt, ticker PCY. It offers a very nice, a very diverse collection of country allocation. It actually equal weights the country. So, you don’t any over weights to any one particular country. And then for local currency bonds we'd recommend, WisdomTree Emerging Markets Local Debt, ticker ELD, and ELD is actually an actively managed bond fund. So, there is actually investment committee that does a tiering strategy, where they will allocate more money to the countries they think are the better credit risks.

Glaser: So certainly there have been some pretty aggressive flows into these funds. Are there any risks that investors should keep in mind?

Strauts: I will say that the flows are kind of a concern for me right now because year to date there has been $21 billion in net flows into the category, which is actually has increased the category assets by 41% just in 10 months, so that’s a very large increase in any one category. So there is a risk that this is maybe a hot-money sector where people are seeing that they getting very low yields in the U.S. and they are moving money to high-yield bonds and emerging-markets debt to try to get some sort of yield.

I will say that the yields aren’t as attractive as they used to be because a year ago where you can get yields close to maybe 6%, today a lot of these funds have yields that are below 4%, which for an investment in another country, below-4% yields, while still attractive versus Treasuries, are not as attractive as maybe they were a few years ago.

Glaser: Tim, thanks for your thoughts today.

Strauts: I’m glad to be here.

Glaser: For Morningstar, I am Jeremy Glaser.

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