Emerging market debt ETFs back in focus as investors hunt yield

Aug 25th, 2016 | By | Category: Fixed Income

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The adoption of negative interest rate policies by various central banks in developed markets has resulted in investors turning to emerging market debt in their hunt for yield.

Comments from SPDR ETFs showcase potential for emerging markets

Antoine Lesné, Head of SPDR ETF Strategy & Research EMEA at SSGA, believes emerging market debt may present an attractive opportunity to investors.

In a recent thought piece, Antoine Lesné, Head of SPDR ETF Strategy & Research EMEA, at State Street Global Advisors, shared his top five reasons why emerging markets currently present an attractive opportunity to investors.

Firstly, macro activity has been rebounding from depressed levels. “After a prolonged downturn during most of last year, Emerging Markets Manufacturing PMIs have been recovering of late,” says Lesné.

As the graph below shows, the emerging markets purchasing managers indices have risen to 50.3 (as of 31 July 2016), ending their virtually unbroken run below 50 (representing an expected contraction in the economy) since February 2015. The break above 50 signals that purchasing managers at manufacturing, construction and services firms are, in aggregate, bullish about the economy.

Source: Bloomberg.

Sources: SSGA, Bloomberg.

Secondly, even taking inflation into account, yields on emerging market debt look very attractive compared to often below-zero real yields in developed markets. According to Lesné: “Comparing developed and EM inflation-linked universes, it’s clear that the real yield differential remains advantageous. Nominal yield differentials would show a similar pattern, too. Adjusting for inflation always gives an interesting picture; and the yield allure of EM inflation-linked bonds is also generous.”

As evidenced by the graph below, yield differentials between the two are currently above 3%.

Source: SSGA, Barclays POINT.

Source: SSGA, Barclays POINT.

Thirdly, Lesné points out that monetary policy in emerging markets is generally accomadative of economic growth. “A number of EM central banks have been taking an easing stance. Earlier this year — after a bout of currency weakness pushed up inflation — some central banks also pushed up rates. However, now forex volatility and lower inflationary pressure have allowed EM central banks to engage in easing policies.

“The earlier tightening bias was more pronounced in commodity-producing countries. Among the largest countries in EM local currency indices, Mexico hiked by 50bps since last May. Meanwhile Turkey and Russia actually eased over the past 3 months by 0.75–1%. The Central Bank of Turkey is expected to announce its policy rate on Tuesday, 23 August and may well be under political pressure to adopt a further accommodative stance.”

As the following graph illustrates, Lesné’s fourth point is that emerging market currencies have been significant drivers of return year-to-date. “Emerging Market currencies have rallied back against a backdrop of stabilising commodity prices and the delayed timetable for Fed rate hikes. It is worth noting that the Turkish lira has come back strongly this month, however it is also worth highlighting that there are potential rating agencies downgrades being awaited and may halt this recovery.”

Source: SSGA, Barclays POINT.

Source: SSGA, Barclays POINT.

Lastly, Lesné argues out that international investor flows into emerging markets are starting to recover strongly, opening up an opportunity for investors to ride the momentum of the market flows.

“After the China-induced weakness last year and the challenging start of the year, international investor flows into emerging markets have come back en masse. Nevertheless, a pause occurred ahead of the Brexit vote, highlighting the overall uncertain environment we currently operate in. However, data in June and July may have signalled that the time is right to go back to the emerging world and $5.7bn has flowed into EMEA-domiciled EM debt ETFs year-to-date.”

Source: Institute for International Finance, Bloomberg.

Source: Institute for International Finance, Bloomberg.

Lesné concludes: “Overall, China remains a potential dampener of appetites, but the danger has not awakened yet and there is currently little reason for the tide to turn in the weeks ahead. Nevertheless, this week’s speech by Fed Chair Yellen at Jackson Hole may prompt a degree of caution, depending on whether she sounds more hawkish than current expectations. A more hawkish Fed could trigger a pause in performance by strengthening the US dollar. However as the case for lower for longer remains this could actually give rise to further entry points.”

Investors looking for emerging markets fixed income exposure may consider the following ETFs which cover that space:

The SPDR Barclays Emerging Markets Local Bond UCITS ETF (LSE: EMDD) tracks the Barclays Emerging Markets Local Currency Liquid Government Index, a country-constrained index (maximum 10%) designed to provide a broad measure of the performance of liquid local currency emerging markets debt. The fund has $1.9bn in assets under management (AUM) and a total expense ratio of 0.55%.

The SPDR Barclays EM Inflation Linked Local Bond UCITS ETF (LSE: EMIL) tracks the Barclays Emerging Markets Inflation Linked 20% Capped Index, designed to provide a broad measure of the performance of investible local currency inflation linked bonds, issued by various emerging markets. A country cap of 20% is applied. The fund has AUM of $42m and a TER of 0.55%.

The iShares JP Morgan $ Emerging Markets Bond UCITS ETF (LSE: SEMB) tracks the JP Morgan EMBI Global Core Index, a composition of US dollar-denominated bonds from emerging market countries. The fund has AUM of $6.4bn and a TER of 0.45%.

The iShares $ Emerging Markets Corporate Bond UCITS ETF (LSE: EMCP) tracks the Morningstar Emerging Markets Corporate Bond Index, representing US dollar-denominated corporate bonds from emerging market countries. The fund has AUM of $220m and a TER of 0.50%.

The Lyxor Emerging Markets Local Currency Bond UCITS ETF (LSE: EMBD) tracks the JP Morgan GBI-EM Global Diversified Index, composed of government bonds from emerging markets denominated in local currencies. The fund has AUM of $750m and a TER of 0.55%.

The PIMCO EM Advantage Local Bond Index Source UCITS ETF (LSE: EMLB) tracks the PIMCO Emerging Markets Advantage Local Currency Bond Index, a composition of local currency-denominated emerging markets debt, weighted in the index according to country GDP. The fund has AUM of $110m and a TER of 0.60%.

The Amundi ETF Global Emerging Bond Markit iBoxx UCITS ETF (Euronext Paris: AGEB) tracks the Markit iBoxx USD Liquid Emerging Markets Sovereigns Index, a composition of liquid sovereign bonds issued by the 20 largest emerging market countries. The fund has AUM of $65m and a TER of 0.30%.

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