A Unique Way to Invest in Emerging-Markets Sovereign Bonds

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.

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.

From one angle, the strategy appears to be working. For instance, over the trailing five years through April 2015, the fund ranked in the top 5% of all open-end funds. That said, the fund's U.S.-dollar emphasis and its avoidance of hard-hit emerging-markets corporate debt have been in market favor during most of that stretch--should local-currency or corporate emerging-markets debt return to market favor, the fund's absolute and relative performance may suffer. The fund has also exhibited greater return standard deviation than market-cap-weighted emerging-markets sovereign-bond indexes. For example, over the trailing five years through April 2015, the fund's return standard deviation (8.4%) was greater than that of the Barclays EM USD Sovereign Bond Index (7.0%).

The fund may act as a diversifier to an investor's U.S. bond portfolio. For example, over the trailing five years through April 2015, the fund's monthly returns were 0.59 correlated to the Barclays U.S. Aggregate Bond Index. Further, the fund has exhibited low correlation to U.S. equities. For instance, during the same time period, the fund's monthly returns were 0.31 correlated to the monthly returns of the S&P 500. However, the fund may not be as great of a diversifier as local-currency emerging-markets funds.

The fund is likely best used as a satellite holding for investors looking to diversify their core U.S. bond holdings or as a tactical tool for investors who think U.S. dollar-denominated emerging-markets bonds are relatively cheap.

Fundamentals Demand for emerging-markets bonds has skyrocketed during the past few years on strong fundamentals and higher yields. This has caused the fund and its index to change the way it invests in emerging-markets sovereign debt. For instance, in 2010, Deutsche Bank, the fund's index provider, opened up the index from the 25 most attractively valued sovereign bonds in 19 countries to the three most attractively valued bonds in 25 different emerging-markets countries. This has made the index easier to track and the fund more diversified. For instance, prior to the March 2010 index change, the fund's portfolio held roughly 25 securities and exhibited tracking error in excess of 0.20%. However, over the trailing year through April 2015, the fund's portfolio held roughly 80 securities and tracking error was only 0.04%.

Because the fund targets emerging-markets sovereign bonds with maturities greater than three years and has no maturity cap, it tends to have a longer duration than aggregate U.S. dollar-denominated emerging-markets sovereign-bond indexes. For example, as of April 30, 2015, the fund's duration (8.4 years) was longer than that of the Barclays EM USD Sovereign Bond Index (7.4 years). This means that the fund is more sensitive to interest rates than the broad aggregate sovereign index, which could hurt investors if interest rates rise. While the bonds are issued by foreign governments, they will react to U.S. interest rates because the bonds are issued--and paid back--in U.S. dollars.

The fund's yield to maturity (6.4%) was above its trailing five-year monthly average (5.6%) through April 2015, which may imply that the bonds are trading cheaply relative to history.

Portfolio Construction The fund tracks the Deutsche Bank DBIQ Emerging Markets Liquid Balanced Index, which includes U.S. dollar-denominated emerging-markets sovereign debt with more than three years until maturity. To construct the index, Deutsche Bank first screens for the three cheapest sovereign bonds in each of the emerging-markets countries in its universe. If more than two bonds share the same valuation characteristics, the most liquid bond is selected. If the country does not have three liquid bonds, the index will choose between zero and two bonds. Once the final bond list is created, it weights each bond so that each country has an equal weighting of roughly 4%. Unlike traditional market-cap-weighted bond funds that are rebalanced monthly, the fund is rebalanced and reconstituted quarterly. Each year, Deutsche Bank's index committee meets to decide which sovereign debt is eligible for inclusion. In 2015, 25 emerging-markets countries were eligible, up from 19 in 2010.

The fund changed its methodology in March 2010. While it originally only included a total of 25 of the most attractively valued bonds, the index now allows for three bonds from each approved country.

The fund uses sampling to track its index, meaning it buys only a representative subset of the index's constituents, instead of every bond. The fund has done a good job tracking its index. Over the trailing year through April 2015, the fund's tracking error was 0.04%.

Fees The fund charges an annual expense ratio of 0.50%, which is in line with the emerging-markets bond category average (0.52%). Over the trailing year through April 2015, the fund lagged its benchmark by 0.57%, which is roughly in line with its expense ratio.

Alternatives

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