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Thursday, February 12, 2015

Emerging Market Bonds No...Stocks Yes

I have written several times about the inadvisability of investing in emerging market bond funds. The yield pickup vs US $ bonds in my view doesn't offset the additional risk. Investing in emerging market bonds adds political and currency risk. Additionally, emerging market bond ETFs are concentrated in the emerging market countries with highest currency and country risk rather than a broad range of emerging market countries.
The strongest economies in the emerging markets are those countries that run current account surpluses and thus are not borrowers in the international bond market.So the countries with the strongest economies and equity markets are not accessed with bond ETFs. There is an additional disadvantage as well ,strong economic growth is often accompanied by higher interest rates/lower bond prices. So it is quite possible strong economic growth which would be good for stocks would be bad for bonds.

Bottom line.... if one is looking to gain exposure to emerging markets an investor is much better off holding an ETF of emerging market stocks vs bonds. This gives exposure to the strongest growing emerging market economies. The bond have similar currency risk and political risk as the equities but unlike the equities which have unlimited upside and downside potential the bonds have limited upside and unlimited downside potential (through default).

An example of the divergence between emerging markets stocks and bonds can be seen in recent developments.
From the WSJ

Emerging-Market Currencies Tumble as Worries Over Greece, Ukraine Escalate

Indonesia’s Rupiah Sinks as much as 1%, While South Africa’s Rand Hovers Close to Weakest in Over a Decade

Bond markets are also tumbling, sending yields surging and pointing to investors also pulling out of these markets. Yields move inversely to prices.
For investors, the weakness in Asia’s foreign-exchange markets, which have performed relatively well to their emerging market peers so far this year, is a surprise. As countries in Latin America and emerging Europe have grappled with domestic economic and political challenges, Asia has been resilient with signs of proactive new governments and central banks, and lower currency volatility.
Local currency bonds in Indonesia, Turkey, Thailand and the Philippines were top performers in 2014. Just weeks ago, yields on Indonesia’s bonds fell to multiyear lows as foreign investors poured into local government bond auctions.
But the currency’s sudden plunge Thursday had traders and dealers saying the central bank was intervening and had sold $50 million to $100 million.

The consequeences can be seen in year to date performance the broad emerging market stock ETF(ticker IEMG) ytd is +.9% while the local currency bond ETF (ticker EMLC) -3%

Growth of $100,00 IEMG(green) EMLC (blue)

The reason for the divergence as noted can be seen in the country allocation Below is the country allocation for IEMG the Emerging Market Stock ETF


















And Here is the allocation by country and currency of EMLC the local currency emerging market
by % 

Poland  10.28
South Africa 911
Malaysia 9.09
Brazil      8.65
Mexico  8.02
Turkey  7.97
Indonesia 7.00
Colombia 6.69
Thailand   6.52

Hungary   4.76
    • C

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