What’s behind the run-up in emerging market bonds?

Emerging market bonds have gotten a lot of attention this year. When choosing a fund, consider sustained performance rather than short bursts.

This year has seen a resurgence of interest in emerging market (EM) bonds. Many investors who had been scared off the asset class in the months following the U.S. presidential election moved back in. Initial concerns that protectionist policies could hurt EM economies and investments abated after the new administration stepped into office. As a result the category has done surprisingly well since the start of the year: $3.4 billion has come into EM bond ETFs, and the J.P. Morgan EMBI Global Core Index has returned a robust 5.17%. (Source: Bloomberg, through 4/18/17)

This resurgence in interest in EM debt, and the growing popularity of index ETFs as an investment vehicle, has led some to question whether an ETF is an effective way to invest in the asset class. As a category, EM bonds tend to be challenging to manage, with more limited liquidity and higher transaction costs than other sectors of US dollar-denominated debt. Information can also be harder to come by, potentially creating opportunities for astute active managers to outperform. This raises an important core question for investors: Which asset classes have been better suited for index management, and which for active?

Let’s take a look at historic EM bond performance and see how the iShares JP Morgan USD Emerging Markets Bond ETF (EMB) has fared. Below we compare EMB’s performance to that of the active EM bond funds in the Morningstar fund database.

We evaluate performance two ways. First, we look at after-fee returns. We have weighted active mutual funds by their assets under management; this gives us a sense of the experience of the average investor dollar. Second, we look at the percent of active funds that EMB has outperformed over different time periods. These results are not weighted, but simply measure the number of funds.

chart-em-bonds-v5

For standardized performance for EMB, please click here. The top chart shows that over the past year the average actively managed EM bond fund has outperformed EMB fairly handily. However, we also see that over longer periods, EMB has had higher returns. Fees likely play a role in this: EMB has an expense ratio of 0.40% versus a net average expense of 1.21% for the active mutual funds.[1]

On the second chart we see a similar pattern as EMB outperformed only 28% of the managers in its peer active universe over the past year. However, EMB has outperformed more than half of the active mutual funds over longer time frames. EMB is a market capitalization-weighted index fund. In this illiquid, high-transaction-cost market, fewer than half of the active mutual funds in the U.S. have been able to beat EMB since its inception nine-plus years ago. The number of outperformers is even lower for three- and five-year periods. And keep in mind that these return numbers are pre-tax. EMB has never paid out a capital gains distribution in the fund’s history, while many of the funds in the active mutual fund universe have. Over the past three calendar years, 53% of active funds in Morningstar’s U.S. Emerging Markets Bond Category have paid at least one capital gain. (Source: Morningstar, as of 12/31/2016).

So what can we take away from this analysis? First, management fees matter. High fees can create a very challenging hurdle for an active manager to overcome over time. Second, make sure to look at longer-term track records when evaluating funds. As of March 31, there were some active funds that had very good one-year performance. Some of these funds may have been correctly positioned for the rally in energy-related assets in 2016, which boosted overall EM debt returns. But the numbers show that many of these managers have been unable to sustain strong performance over longer time periods. Given this trend, investing in funds based only on recent performance may lead to disappointment.

Finally, EM bonds as an asset class can lend itself to both index and active management. High transaction costs and poor liquidity can create potential alpha opportunities, but they also create frictions that can make it more difficult to generate alpha. There are successful active EM bond managers out there, but it turns out that many of them failed to outperform EMB over long periods of time. For investors looking for low cost EM bond exposure, EMB may be worth considering. In fact, EMB recently crossed $10 billion in assets (Source: BlackRock, as of 4/3/2017).

One other important dimension to this conversation is exposure. A broad index ETF such as EMB is designed to provide exposure only to U.S. dollar-denominated sovereign bonds. But it doesn’t include other EM asset classes like corporate bonds or local currency debt. There are ETFs for these asset classes, but there isn’t one index ETF that gives exposure to all three and moves between them depending on market opportunities. If that’s what you are looking for then it may be worth considering an active fund. But make sure that the fund has a successful long track record, keep an eye on those management fees, and remember that choosing the winners isn’t easy.

For more information about the differences between iShares ETFs and mutual funds, click here.

[1] Net expense ratio shown for EMB reflects contractual fee waiver in place until 2/28/23. Gross expense ratio is 0.59%. Source for average: Morningstar U.S. EM Bond Category, as of 3/31/2017.

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

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

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 and in concentrations of single countries.

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.

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