After several months of not hearing much about emerging market (EM) bonds (other than “Where’s the exit?”), we have recently been fielding questions on whether there is value in this space. A key focus is the relative value of USD denominated EM debt relative to other fixed income sectors.

Let’s review the basics. A lot of investors evaluate fixed income sectors by looking at the level of yield they might receive for a given level of risk. We continue to explore how investors consider interest rate risk and portfolio positioning in the current environment. In addition to interest rate risk, there is substantial emphasis on the yields available for different levels of credit risk, which is essentially the risk that an issuer will not make regular coupon payments or will not be able to pay back principal. Credit ratings provided by third party agencies like S&P and Moody’s are often used as a way of gauging the credit risk of an issuer. It essentially measures a debtor’s ability to service and pay back its obligations.

At a high level, bonds are divided into two major categories: investment grade and high yield. Investment grade is defined as ratings at or above BBB- for S&P or Baa3 from Moody’s, and high yield is defined as ratings below those levels. Many of the fixed income ETFs in the market provide exposure to either investment grade or high yield debt. For example, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), provides exposure to higher quality corporate bonds while the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), provides exposure to lower rated corporate issuers.

As we know from the risk-return tradeoff, the higher the level of credit risk an issue has the higher the yield will likely be. Credit risk is often measured with a metric called Option Adjusted Spread or OAS, which considers the additional yield an investor is paid over and above the yield on a similar Treasury security. If we compare the credit spreads of different corporate ETFs to their fund ratings we find a typical upward sloping curve that reflects the fact that investors will require more yield to compensate for higher levels of credit risk.

Here is an illustration of this relationship using ETFs with a range of levels of credit risk:

OAS

Source: BlackRock as of 5/9/2014
For more information on S&P fund credit ratings, please click here.

So where does EM debt fit into the risk versus return landscape? Typically EM lies somewhere in the middle, as the EM bond universe contains a combination of investment grade (Chile, Malaysia, Mexico and others) and high yield (Ukraine, Argentina, Venezuela) issuers. This changed in May/June 2013 as investors became concerned about credit risk and yield spreads widened in response. Since that time we have seen a steady tightening of investment grade and high yield credit spreads across the board as investors have moved back into those sectors. EM spreads have tightened some as well, but not nearly as much. As a result, the yields on EM debt appear to be unusually wide given the credit quality of the issuers. EM credit spreads are trading near those for the high yield market, even though almost 70% of the EM issuers in a broad EM vehicle, like the iShares Emerging Markets USD Bond ETF (EMB), are investment grade.

OAS2

Source: BlackRock as of 5/9/2014
For more information on S&P fund credit ratings, please click here.

The above chart highlights the divergence in spreads that has occurred since 2012. The question for investors today is, will EM rally versus corporate bonds? It’s hard to say. Keep in mind that part of what is keeping EM wide is that the universe, and in particular EMB, include exposure to the debt of countries that have dominated headlines lately. This includes Russia, which makes up 5.61% of EMB, Ukraine which makes up 2.85%, and Brazil which makes up 6% (Source: BlackRock as of 5/1/2014).

It is certainly possible that EM debt can remain at elevated spread levels if we continue to see political and economic challenges in the issuing countries. At the same time we are seeing some investors move back into the sector as evidenced by the $584 million of flows into EMB this year through May 1st (Source: Bloomberg). Bottom line, for investors looking to add yield to a portfolio, EM debt may be an alternative they should take a closer look at. Just remember that, as always, yield isn’t free.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

Holdings are subject to change.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets, in concentrations of single countries or smaller capital markets.

Investopedia and BlackRock have or may have had an advertising relationship, either directly or indirectly. This post is not paid for or sponsored by BlackRock, and is separate from any advertising partnership that may exist between the companies. The views reflected within are solely those of BlackRock and their Authors.

Related Articles
  1. Chart Advisor

    Gold Struggles to Climb Higher and May Fall Soon

    Traders will be watching the price of gold over the coming weeks. We'll take a look at how a couple major moving averages are suggesting that the next move could be lower.
  2. Economics

    Is a Recession Coming?

    In the space of a week, the VIX Index, a measure of market volatility, spiked from 13, suggesting extreme complacency, to over 50, evidencing total panic.
  3. Mutual Funds & ETFs

    ETF Analysis: United States Brent Oil Fund

    Learn more about the United States Brent Oil exchange-traded fund, the characteristics of the fund and the suitability and recommendations of it.
  4. Mutual Funds & ETFs

    ETF Analysis: ProShares Ultra Bloomberg Crude Oil

    Find out more about the ProShares Ultra Bloomberg Crude Oil ETF, the characteristics of UCO and the suitability and recommendations of UCO for investors.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI Hong Kong

    Learn about the iShares MSCI Hong Kong fund, which invests in various equities of companies listed on the Hong Kong Stock Exchange.
  6. Mutual Funds & ETFs

    ETF Analysis: Vanguard Small-Cap Growth

    Take a close look at the Vanguard Small-Cap Growth ETF, which focuses on domestic small-cap equities with a fundamental growth strategy.
  7. Mutual Funds & ETFs

    ETF Analysis: First Trust Dorsey Wright Focus 5

    Take a closer look at the First Trust Dorsey Wright Focus 5 ETF, a unique and innovative fund of funds based on momentum and relative strength.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares National AMT-Free Muni Bond

    Take an in-depth look at the iShares National AMT-Free Municipal Bond ETF, a highly diverse and very popular muni bond fund.
  9. Mutual Funds & ETFs

    Top 3 Switzerland ETFs

    Explore detailed analysis and information of the top three Swiss exchange-traded funds that offer exposure to the Swiss equities market.
  10. Investing News

    Mexican Energy, Telecom Reforms Please Foreign Investors

    Two years into his first term, Mexican President Enrique Peña Nieto is following through on radical campaign promises he made to Mexican citizens for sweeping multi-industry reform.
RELATED TERMS
  1. Yield To Maturity (YTM)

    The total return anticipated on a bond if the bond is held until ...
  2. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  3. Security

    A financial instrument that represents an ownership position ...
  4. Brazil, Russia, India And China ...

    An acronym for the economies of Brazil, Russia, India and China ...
  5. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  6. Credit Rating

    An assessment of the credit worthiness of a borrower in general ...
RELATED FAQS
  1. What are the maximum Social Security disability benefits?

    The maximum Social Security disability benefit amount for a single eligible person in 2015 is $1,165 per month, but you can ... Read Full Answer >>
  2. What is the relationship between the current yield and risk?

    The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>
  3. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  4. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  5. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>
  6. How does the bond market react to changes in the Federal Funds Rate?

    The bond market is highly sensitive to changes in the federal funds rate. When the Federal Reserve increases the federal ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!