Emerging market bond ETFs not so safe right now

Traders hoping to limit downside risk with emerging markets bond ETF funds instead of stocks are getting nervous as once-high-flying funds falter. However, those looking to lock in big yield may get excited soon.

The Barclays Capital Emerging Markets Local Bond ETF (EBND, quote) has sunk 4.2% so far this month, somewhat unceremoniously reversing the 7.5% advance we saw from the new year until the markets started caving in late April.

While the losses so far haven’t been nearly as extreme as those we’ve seen among emerging stock funds, it’s still nothing like the “principal protected” performance that Western traders have come to expect from Treasury-oriented fixed income portfolios.

Far from steady, bond funds focused on emerging markets tend to be roughly as volatile as U.S. stock funds. In good times, the combination of relatively high local interest rates and strong domestic currencies sets up a virtuous cycle that boosts real returns for dollar-based shareholders and beckons fresh money in.

But when the situation deteriorates, speculators rush back out, leaving serious money in significantly deflated assets. That’s where we are now, with foreign interest rates declining and many key emerging market currencies on the run.

Things can get worse before they get better. When the emerging debt funds capitulated in September, EBND and its counterparts dropped 11% to 12% in about three weeks.

That’s not the kind of downside that Western fixed income normally risks, but on the other side of the coin, the upside can also be substantial.

At a current price of about $30.35 per EBND share, the bonds in the portfolio are generating interest payments at an annualized rate of 5.6%.

That’s a 4.5% premium over a Treasury portfolio of similar duration and a substantial base for future outperformance when market sentiment turns back around.

Other emerging market bond funds have been beaten down to similarly elevated effective yields. If anything, EBND has fared better than the pack and so its yields haven’t blown out nearly as much.

For example, the Market Vectors Aggregate Latam Bond (BONO, quote) invests in a mix of dollar- and foreign-currency-denominated debt from Mexico, Colombia, Brazil and other Latin countries.

Lingering excitement over Brazilian bonds and a sense that Mexico is relatively shielded from the uncertainties facing the region have made it one of the better performers in the emerging debt group, but it’s still down 4.8% so far this month.

Right now, it yields 6%. If it were to retreat as much as it did back in October, traders would be looking at an effective yield closer to 6.5% — a full 5.5 percentage points more than Treasury paper of equivalent duration currently pays.

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