The Emerging Market Bond ETF – Friend Or Foe?

The recent hard times in the US have helped many investors to take the blinders off and realize that there are many reasonable investment opportunities well away from Wall Street. Global trading and seamless digital communications have made investments in foreign securities (both stocks and bonds) much more cost-efficient for regular investors. One fast-growing class of investments, the emerging market bond ETF, can offer an attractive risk/reward proposition. They are not without their own idiosyncratic risks, however.

Emerging market bond yields have held up relatively well next to more traditional U.S. treasuries or domestic corporate bonds recently. The average emerging market bonds ETF is yielding in the 5- 6% range* versus less than 3.5%* for domestic bonds. There are many reasons for this: higher risk and lower liquidity among them, but part of it is undoubtedly the reshuffling of the deck caused by the recent economic crisis. With growing economies and a sure footing, many of these emerging market economies offer dynamic alternatives to the sluggish (and low-yielding) American bond market. Additionally, the new playing field has reversed common perception. Something else the average emerging market debt ETF has going for it: in many cases, these emerging economies are better positioned to repay their debts and increase market shares than comparable markets in the developed world.

While a higher yield is what lures many investors into the emerging market bond ETF arena, diversification is what (or at least should) keeps them there. Any experienced investor knows the value of bonds in a diversified portfolio. Emerging market bonds can be a reasonable way to gain some additional diversification benefits disconnected from domestic markets and, in the context of a portfolio with only a modest 5-10% allocation to these emerging debt funds, should not add an unreasonable amount of risk.

Two of the more popular and reasonably-priced emerging market bond ETFs are the iShares JP Morgan Emerging Bond Fund (EMB) and PowerShares Emerging Markets Sovereign Debt Portfolio (PCY). While they have performed similarly in recent months, these funds utilize distinct approaches. Differences include the indexes used, the safety guidelines employed, and interest rate sensitivity, and how the funds hedge against fluctuations in the value of the dollar relative to other currencies. A little research should help you determine which one best reflects your investment style. If you plan to seriously consider these (or any) funds, I highly recommend getting yourself a free Morningstar account and spend some time familiarizing yourself with some of the fund statistics most important to you (for me, these are the expense ratio and portfolio turnover).

Obviously, there are no guarantees in investing, but there are many ways to create a balanced portfolio that reduces risk while maximizing yield. An emerging market bond ETF market can be a great place to park money where it will be one-step removed from the regular ups and downs of the US economy.

* Yield data accurate as of 3/7/2011