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ETF Specialist

A Unique Way to Invest in Emerging-Markets Sovereign Bonds

This fixed-income ETF screens for the most-undervalued emerging-markets sovereign bonds and weights each country equally.

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Market-cap-weighted fixed-income indexes, while the market standard, are not without their issues. The biggest complaint investors have is that these indexes tend to invest in the most indebted countries and companies instead of underlying fundamentals.  PowerShares Emerging Markets Sovereign Debt Portfolio (PCY), a strategic-beta fixed-income fund that tracks a non-market-cap-weighted index, aims to fix that problem in the emerging-markets bond Morningstar Category.

The fund tracks an index of U.S. dollar-denominated emerging-markets sovereign bonds. PCY differs from traditional market-cap-weighted exchange-traded funds by applying a valuation screen and using equal country weightings. The fund uses bond z-spreads to screen for the three most undervalued sovereign bonds in each of its index's 25-country universe. The z-spread calculates a bond's discounted future cash flow across the yield curve instead of just at maturity. Bonds with a higher z-score are considered to offer better compensation above traditional risk-free rates. Once the most undervalued bonds are found, they are weighted so that each country receives an equal weighting of roughly 4%. Equal-weighting may also offer a slight improvement in return by systematically selling recent winners and buying recent losers when it rebalances.

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Thomas Boccellari does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.