Now is possibly not the best time to launch an emerging markets bond fund

With the euro zone spooking global traders again, last week was probably not an ideal time for launching a new emerging markets bond fund — especially one like the Market Vectors Emerging Markets High Yield Fund (HYEM, quote), which specializes in low-rated debt.

Image courtesy Márcio Cabral de Moura: http://www.everystockphoto.com/photographer.php?photographer_id=63973

Caracas, the capital and largest city of Venezuela

On paper, HYEM looks intriguing enough. The fund invests in bonds from outside Western Europe, Canada, Japan and the United States issued by entities with non-investment-grade credit ratings; so in theory the yields should be impressive.

But when the fund launched last Wednesday, the “risk off” mentality was back in control of the markets.

Money has been flowing out of riskier assets when it can, leaving broad emerging market stock funds like EEM (quote), for example, down 2.1% since last Wednesday morning.

And in relatively illiquid funds, money can’t flow out as buyers effectively go on strike. That’s what’s happened with HYEM, which has the double strike of being new and explicitly high-risk against it.

The casual observer might think HYEM is holding up remarkably well. The fund opened trading at $25.03 a share and is now up a lofty 3 cents.

However, after an initial flurry of trades from market makers priming the engine on a new ticker, volume has stalled at a less-than-enthusiastic 962 shares a day.

And in the meantime, as you might expect, the underlying value of the emerging markets bonds in the portfolio is deteriorating, even though as yet the HYEM share price doesn’t reflect the losses.

As of Friday night, HYEM traded at a premium of 0.68% to its underlying assets, which means the fund is currently priced above what it would cost to replicate its holdings on the open market.

While the premium isn’t huge in absolute terms, by the standard of more liquid ETFs it’s still pretty large.

The largest emerging markets bond ETF (EMB, quote), for example, towers over HYEM with $4.7 billion in assets and average turnover well above 500,000 shares a day. And while it is also trading at a slight premium to assets, it’s very slight at 0.5% — about 50 cents per share.

By comparison, HYEM hit the market with under $10 million under its belt and has established a track record of under 4,000 shares a day. And given the premium disparity, anyone buying HYEM at this level is still paying a little extra for the privilege.

Granted, it’s hard for U.S. retail investors to buy into emerging markets bonds in the first place, much less know which ones to pick. HYEM, for example, focuses on debt from companies in Venezuela, China, Indonesia and other hard-to-crack countries, as well as high-yield debt from names like Russian telecom carrier VimpelCom (VIP, quote), which may be familiar to Emerging Money readers.

And the sheer exotic nature of HYEM’s investment focus will probably win it plenty of trader interest in the long term. While no yield numbers have come out yet, the portfolio’s bonds currently promise to pay well over 8.8% a year if held to maturity, close to double the 4.7% yield on EMB.

But there’s rarely a good reason to pay a premium for anything, no matter how exotic it is. Prices tend to reflect underlying value. Unlike truly exotic instruments, HYEM’s bonds are publicly traded overseas and so their value will fluctuate day by day.

Right now, it looks more likely that their value will fluctuate downward if the current “risk off” mentality remains in charge of the markets. That means the premium is more likely to increase as HYEM’s bonds deteriorate in value, while a lack of buyers keeps the ETF price locked more or less in place.

That’s not a recipe for confidence in the near term, and sooner or later reality will kick in and give traders hungry for these assets a chance to come in at a discount.

Speaking of discounts, EEM is trading at 31 cents a share less than its underlying assets are worth. Does that make emerging stocks a buy? Not necessarily, but it’s definitely a big data point in their favor.

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