Investors are once again looking at emerging market debt as a source of potential returns as economies across the globe start to recover from the coronavirus turmoil.
According to Invesco’s latest global fixed income survey, some 72% of respondents have an allocation to emerging market debt compared to just 49% in 2018.
With developed market bonds trading at record-low yields due to ongoing quantitative easing measures from the major central banks, emerging market debt looks like an attractive proposition for yield-hungry investors.
When looking to access local currency emerging market government bonds through the ETF wrapper, investors in Europe should look no further than two products from State Street Global Advisors (SSGA) and BlackRock.
It is important to note there are some significant differences between Europe’s largest local currency emerging market government bond ETFs, the $5.8bn iShares J.P. Morgan EM Local Govt Bond UCITS ETF (IEML) and the $3.1bn SPDR Bloomberg Barclays Emerging Markets Local Bond UCITS ETF (EMDD).
Starting with the similarities, IEML and EMDD were both launched in mid-2011 and have similar total expense ratios (TERs) with BlackRock’s product undercutting SSGA’s by five basis points at 0.50%.
Index selection
IEML and EMDD both tracked the Bloomberg Barclays Emerging Markets Local Currency Liquid Government Bond index until July 2017 when BlackRock’s IEML was switched to the J.P. Morgan GBI-EM Global Diversified 10% Cap 1% Floor index.
BlackRock said the move occurred after clients asked for a change to the JPM index which has some significant differences to the Bloomberg equivalent.
Both ETFs track their respective indices through sampling techniques. In the fixed income space, indices tend to include a large number of bonds meaning they are too expensive to fully replicate.
Therefore, sampling enables the portfolio managers of the ETFs to buy certain bond issuances that will mirror the performance of the index but keep trading costs lower. EMDD offers exposure to a larger number of securities – 414 – versus just 218 for IEML.
Furthermore, EMDD has an average longer duration of 8.8 years versus 7.5 years for IEML while BlackRock takes part in securities lending while SSGA does not for its European-listed fixed income ETFs.
Performance
A crucial difference between the two ETFs is EMDD’s top exposure is to South Korean (10%) bonds, a country many would consider a developed market.
IEML, meanwhile, does not include South Korean government bonds and instead has big weightings to Mexico with 10% and Indonesia with 9.7%.
This is one of the key considerations when investing in EMDD as investors may already have South Korea as part of their developed market government bond bucket.
Highlighting this, the SPDR Bloomberg Barclays Global Aggregate Bond UCITS ETF (GLAG) has a 1.2% weighting to South Korea, far higher than any emerging market exposure.
However, with emerging market bonds performing so badly in recent years, SSGA’s EMDD has significantly outperformed IEML with South Korean bonds acting as more of a safe haven during periods of market stress.
Emerging market debt: To hold, or not to hold?
Since the index change on 12 July, EMDD is down 8.4% versus returns of -13.8% for IEML, as of 24 July, according to data from Bloomberg.
This performance highlights the slightly more defensive characteristics of EMDD over a long-term time horizon and is further confirmed when studying how both ETFs behaved during the coronavirus turmoil. EMDD dropped 19.2% to the YTD low point on 23 March while IEML was down 22.1% over the same period.
Therefore, for more uncorrelated exposure, IEML offers a purer play while EMDD has outperformed over a longer time horizon due to the more defensive nature of its benchmark.
