IShares JPMorgan USD Emerging Markets Bond ETF EMB is a solid choice for low-cost exposure to U.S.-dollar-denominated emerging-markets government bonds. The strategy earns a Morningstar Analyst Rating of Silver because it accurately represents the composition of the market and is one of the cheapest funds in the emerging-markets bond Morningstar Category.
Emerging-markets economies face a lot of idiosyncratic risks, and the bonds issued by their governments and agencies perform more like high-yield corporate issues than U.S. Treasuries. They are more sensitive to credit risk and suffer more severe drawdowns. While in theory this should create an opportunity for actively managed funds to exploit mispricing, the JPMorgan EMBI Global Core Index (the category index), has not been any easy bogy to beat. Historically, investors interested in adding exposure to this area of the bond market would have done well to settle for an index fund. Over the 10 years through June 2020, there was only one fund in the category that outperformed the category index on a risk-adjusted basis.
This fund tracks the JPMorgan EMBI Global Core Index, which includes sovereign and quasi-sovereign entity issued debt, denominated in U.S. dollars, with at least two years remaining until maturity and $1 billion in outstanding face value. The index caps the fund’s largest country weighting to twice the average country’s weighting in the portfolio, before making further adjustments to improve geographic diversification.
Emerging-markets government bonds tend to offer higher yields relative to developed- markets government bonds, given their additional credit risk. The strategy’s market-value-weighted approach relies upon other market participants to set bond prices, free-riding off the market’s collective wisdom and following trends in the issuance of new index-eligible bonds to determine the identities and weights of its holdings. This yields a broad portfolio that effectively diversifies risk and has exhibited lower volatility than the category average.
This portfolio’s focus on U.S.-dollar-denominated bonds removes currency risk. However, it may be more politically palatable for issuers to default on U.S.-dollar-denominated bonds than on debt issued in local currency, as such bonds are primarily held by foreigners.
Credit risk here is high. As of June 2020, about 60% of the fund’s assets were invested in investment-grade debt, with the bulk of the fund’s remaining assets rated below-investment-grade. Although this is about 15 percentage points overweight investment-grade debt relative to the category, it matches other market-value-weighted index funds. Similarly, the fund takes more interest-rate risk relative to the average fund in the category, though this is also in line with similar broad market-value-weighted index portfolios. As of June 2020, the fund’s average effective duration was just slightly less than eight years.
People: BlackRock boasts a large and experienced team reinforced by sector specialists, support teams, and centralized trading desks, mitigating key-person risk and underpinning an Above Average People Pillar rating.
James Mauro and Scott Radell have acted as the fund’s lead portfolio managers since 2011 and 2010, respectively. Mauro joined BlackRock in 2010 after acting as a portfolio manager at State Street for more than 17 years, while Radell joined BlackRock in 2008. They lead a broader team of sector specialist portfolio managers who are supported by a handful of analysts, a separate trading team, and an index research team. This specialization improves execution and scalability, allowing BlackRock to deliver high-fidelity index tracking in a cost-efficient manner. The scope of responsibility is most broad for the senior members of the team, who are responsible for BlackRock’s macro outlook and for strategic research, while the specialists beneath them are responsible for the day-to-day operations of the strategy like processing creation/redemption baskets.
The managers’ compensation is tied to performance, as measured by the tracking difference between the fund and its benchmark. This aligns their interest with investors’. Additionally, BlackRock’s risk and quantitative analysis team provides independent oversight.
Process: This broad, market-value-weighted portfolio reflects the composition of the U.S.-dollar-denominated sovereign emerging debt market. It harnesses the market's collective wisdom about the relative value of each bond in assigning their weight, free-riding off market participants. As a result, it earns an Above Average Process Pillar rating.
The strategy tracks the JPMorgan EMBI Global Core Index, which includes emerging-markets government and government-related bonds denominated in USD. Eligible issues must have at least two years remaining until maturity and a minimum face value of $1 billion. The index limits its largest country weighting to twice its average country weighting, before making further adjustments to improve geographic diversification.
Portfolio: Emerging-markets sovereign bonds denominated in USD tend to be less volatile than local-currency bonds because they don't have direct exposure to currency risk. Although these issues had historically carried greater credit risk, their credit risk is now comparable.
The fund provides broad and diverse exposure to U.S.-dollar-denominated emerging-markets sovereign debt issued globally. At the end of February 2020, the fund owned bonds issued by 59 countries, with Mexico accounting for the largest single-country exposure at just over 5% of the portfolio.
The portfolio contains a fair amount of credit and interest-rate risk, reflective of its opportunity set. As of June 2020, approximately 60% of the fund’s assets were in investment-grade rated bonds. Although this is 15 percentage points higher than the emerging-markets bond category average, it is in line with other market-value-weighted funds in the category. Similarly, the fund’s average effective duration of approximately eight years was about two years longer than the category average but congruent with its market-value-weighted counterparts.
Performance: The fund's performance during the trailing 10 years through June 2020 has been solid, owing to its cost advantage and broadly diversified portfolio. It beat the category average by 59 basis points annually while exhibiting less volatility. The strategy's risk-adjusted performance ranked among the category's best-performing decile as a result.
Bonds issued by sovereign and quasi-sovereign emerging-markets issuers have considerable credit risk. As a result, this strategy is more vulnerable to large drawdowns than most U.S. government bond funds. For example, its maximum drawdown during the trailing 10 years through June 2020 was 15.05%. While this was more than 2 percentage points less than the category average, it was also 11.17% larger than the intermediate government category average.
Additionally, the emerging debt markets are exposed to different sector risks relative to the U.S. government debt market. For example, the Russian and Saudi Arabian economies are dependent on oil production and are thus more vulnerable to downturns in the energy sector. And because these bondholders are predominately foreign from the perspective of the issuing entities, defaulting on these bonds may be more palatable for them than defaulting on local-currency debt.
The fund’s performance during the onset of the coronavirus crisis, from mid-February through mid-March 2020, shows how risky the emerging debt market is. The fund fell by roughly 20% during that time, roughly in line with category average.
The emerging bond market is large and diverse, so manager skill is required for a fund to hang tight to its benchmark. Over the trailing five years through June 2020, the fund’s tracking error was just 0.16%, which was the lowest amount of any index fund in the emerging-markets bond category. The fund trailed its benchmark by 52 basis points annually during this period.