Emerging market debt: is a 5% yield worth the risk?

In sterling terms, the global fixed interest emerging market ETF sector has returned an average 30.7 per cent in the year to date. The sector is one of the best performing of all ETF sectors listed in the UK and emerging market ETFs still yield between 4 and 8 per cent - even after recent outperformance - a stark contrast to the paltry and in some cases negative yields offered by developed markets bonds.

Factors propelling emerging market bonds to the top of the pile include a slower-than-anticipated rate hike cycle by the US Federal Reserve, a calming of tensions over China, rising commodity prices and low interest rates across the developed world.

"The backdrop of improving emerging markets fundamentals warrants a more optimistic approach to investing in emerging assets," says asset manager PIMCO. Since the so-called 'taper tantrum' emerging market crisis of 2013, the asset class looks undervalued and under-invested, making it less precarious than in the past. Add to that better country balance sheets, and and there are more reasons to invest than for yield alone.

But it is not without risk. Emerging market economies and companies have lower credit ratings than developed market counterparts, meaning that default risk is higher. The fate of these bonds is also strongly tied to the decisions of the Federal Reserve. If the US does start hiking rates faster than markets anticipate, money could easily pour out of emerging markets again and the asset class could suffer.

Currency risk is also an issue, particularly in bonds priced in local currencies rather than dollar-denominated (hard currency) bonds. Local sovereign debt has been the best-performing emerging market debt sector this year, but investors in local currency debt are "taking exposure to two risks: local duration and currency risk," says Francesc Balcells, portfolio manager at PIMCO.

However, the low price, cheap currencies and high returns attached to many emerging market bonds provide some protection, particularly compared to developed market bonds which in some cases you might be paying to hold, adds Mr Balcells.

And Laith Khalaf, senior analyst at Hargreaves Lansdown, warns investors to tread carefully. "This is a specialist area which comes with a lot of risk," he says.

However, Alan Miller, founder of SCM Private, argues: "Emerging market bonds have outperformed, but they are one of the few places you can still pick up an attractive yield. And you'd be crazy to invest in UK government bonds yielding not far off zero, after charges."

What do you get in an emerging market ETF?

Emerging market bonds come in hard currency, denominated in dollars, or local currencies, and invest in sovereign government bonds or corporate bonds. The riskiest of these are local currency corporate bonds, which are much more exposed to currency fluctuations and tend to carry a higher default risk than sovereign ETFs issued by countries.

This year local currency bonds have been the star performers but Mr Miller and Mr Khalaf both say they are far riskier than hard-currency bonds due to their currency exposure. Hard currency debt will still expose you to fluctuations between sterling and the dollar, but will be less volatile than local currency.

Local currency bonds could also be more vulnerable to liquidity issues. This is unlikely to be a direct issue for investors buying and selling the ETF as it is a listed fund, but could add costs within it.

Dollar-denominated sovereign bond ETFs include iShares JP Morgan $ Emerging Markets Bond UCITS ETF (IEMB), which tracks the most commonly referenced hard currency emerging market debt index - JP Morgan EMBI Global Core index. The ETF is invested in a globally diverse mixture of bonds, including Turkish, Russian and Argentine debt with 315 holdings in total, and an average duration of around seven years. According to Morningstar, it yields 4.87 per cent and pays out a monthly dividend. In the year to date it has returned just over 30 per cent.

Lyxor UCITS ETF iBoxx $ Liquid Emerging Markets Sovereigns (LEMB) also offers exposure to hard-currency bonds, but tracks the Markit iBoxx USD Liquid Emerging Markets Sovereign Index, which comprises the largest and most liquid emerging market countries issuing dollar-denominated debt. It has 58 holdings and has performed broadly in line with iShares JP Morgan $ Emerging Markets Bond UCITS ETF.

The yield on local currency bond ETFs tends to be higher, for example, iShares Emerging Markets Local Government Bond UCITS ETF (IEML) yields 5.25, but is more volatile than its dollar-denominated counterpart. It has a volatility of 12.8 per cent compared to 9.4 per cent over five years for iShares JP Morgan $ Emerging Markets Bond UCITS ETF.

The smart options

There are also three smart beta ETFs which aim to iron out some of the risk inherent in emerging market bond investing by filtering their holdings according to quality. The recently launched ETFS LOIM Emerging Market Local Government Bond Fundamental GO UCITS ETF (LOCG) weights its constituents based on the credit worthiness of the issuer. The approach is an alternative to traditional market-cap investing which over-weights issuers with the greatest level of outstanding debt. This approach aims to better diversify portfolio risk as well as improve the risk-adjusted returns. This ETF yields 4.7 per cent according to Lombard Odier.

PIMCO Emerging Markets Advantage Local Bond Index Source UCITs ETF (EMLI) weights countries in its index by gross domestic product (GDP) instead of market cap and aims to orientate away from countries with the highest debt burdens. It has performed well recently returning 32.5 per cent in the year to date.

db x-trackers iBoxx USD Emerging Sovereigns Quality Weighted UCITS ETF (XQUA), which launched this year, tracks the Markit iBoxx USD Emerging Markets Sovereigns Quality Weighted Index. It allocates higher weights to countries with relatively solid fundamentals and reduces the weightings of countries with relatively weak fundamentals. There are 302 bonds in this index more than half of which are BBB-rated securities.

Mr Miller likes UBS ETF – Barclays USD Emerging Markets Sovereign UCITS ETF (hedged to GBP) (SBEG), one of the few hedged options in this area. He believes that currency movements could hurt sterling investors so prefers to hedge out that risk. He says: "If you think sterling will fall further, then of course go un-hedged, but if you think you would rather just take the yield then there is a lot to be said for hedging.

Performance (cumulative total returns) and yield of suggested ETFs

Source: FE Analytics, as at 16.08.16. Yield data, Morningstar, as at 16.08.16

London-listed emerging markets debt ETFs

Source: London Stock Exchange, multiple share classes not included