Source research points to attractiveness of EM sovereign bond ETFs

Sep 29th, 2016 | By | Category: Fixed Income

European exchange-trade fund provider Source has released research revealing the relatively low indebtedness of emerging market countries compared to their developed peers.


Paul Jackson, Head of Research at Source.

Of the world’s 20 largest economies, the 10 most indebted countries relative to their economic output in 2015, (including governments, non-financial sector corporates and households) were all from developed markets. Japan (396% of GDP), Netherlands (326%) and France (310%) topped the list, while South Korea (233%) and China (233%) – at 12th and 13th respectively – had the highest total debt among emerging markets, although their levels were still below the global average of 240%.

The below table shows the level of indebtedness relative to GDP for the world’s 20 largest economies.


Source: Source ETFs.

Paul Jackson, Head of Research at Source, commented: “The most striking feature of our analysis is the relative ‘lack’ of debt in emerging economies. Even China, which has been the focus of debt concerns in recent years, was less indebted than the global average in 2015. If investors are worried about debt in China they should really be worried about some other countries, in particular Japan, the Netherlands and France.”

Jackson continued: “Based on their debt fundamentals, emerging markets are better placed than most developed markets, which make the yield premiums on their bonds even more attractive. Indeed, debt/GDP ratios in most emerging countries are well below global norms.”

In addition to having relatively lower debt/GDP ratios, Source’s research also highlights that, on average, emerging markets have a greater proportion of domestically-financed debt relative to externally-financed debt. Foreign debt tends to be more of a threat to an economy than domestically-financed debt as foreign debt is often denominated in the foreign country’s currency. This places several strains on the debt-issuing country – the export sector is under pressure to maintain a surplus required to service the debt or, if the sector cannot manage this, the country is often forced to begin depleting its foreign currency reserves. The debt issuer is also exposed to currency risk which will increase the total foreign debt repayments, in terms of the domestic currency, when the domestic currency is depreciating.

Source notes that countries with particularly low external debt/GDP ratios include Indonesia (34%) and Russia (39%). Traditional “safe-havens” such as Germany (147%) and Switzerland (231%) have high external debt/GDP ratios; however, they also possess significant external assets (their current accounts are continuously in surplus) and their net international investment (the difference between a country’s external financial assets and liabilities) to GDP ratios are 48% and 92% respectively. Russia also has a positive net international investment/GDP ratio at 26%.

“If we are searching for a so-called safe-haven, our analysis suggests Switzerland may be the best placed traditional candidate given that Germany suffers from its euro area associations,” added Jackson. “More controversially, Indonesia and Russia appear to have many desirable qualities but we doubt the market will recognise them anytime soon.”

On the assumption that debt owed by governments is of a higher quality than that owed by corporates, Indonesia and Mexico are the best placed, with corporate debt amounting to less than 25% of GDP. India (48%), Russia (52%) and Turkey (54%) are not far behind. At the other end of the scale are Sweden (154%), the Netherlands (131%) and France (128%). Notably, China’s total debt was 233% of GDP in 2015, of which 156% was owed by the corporate sector. In Japan, 102% of the 396% total was owed by the corporate sector.

Investors sharing the sentiment that the relatively low indebtedness of emerging market economies enhances their investment profile may wish to consider the Source Pimco EM Advantage Local Bond Index UCITS ETF  (EMLB) which trades on the London Stock Exchange and SIX Swiss Exchange. As of 27 September 2016, there is over $134m in assets invested in this ETF.

Unlike many existing emerging market local debt indices, the fund’s underlying index, the Pimco Emerging Markets Advantage Local Currnency Bond Index, bases country allocation on GDP and a country’s capacity to service its debt.

The ETF’s largest country exposures are Russia (15.2%), Brazil (15.1%), India (14.9%), China (14.7%), Indonesia (9.4%) and Mexico (8.8%). The credit rating category to which the fund is most exposed is BAA (40.3%), followed by BB (22.7%), A1 P1 (15.0%) and A (13.8%). The fund has an average duration of 3.6 years and an average yield-to-maturity of 7.1%.

It has a total expense ratio of 0.60%.

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