Fran Rodilosso, Head of Fixed Income ETF Portfolio Management, CFA
November 29, 2018
For investors and allocators looking for exposure to emerging markets local currency bonds, ETFs may provide “one-trade” access to cost effective beta exposure. Emerging markets bonds, as an asset class, represent a wide swath of countries, each with their own distinct trading characteristics, especially in their local markets. ETFs allow investors and asset allocators to bypass the operational and regulatory complexities of trading in many of those countries, while gaining exposure to the underlying bond and currency returns.
The local currency bond market has grown to become the largest part of the broader investable emerging markets debt opportunity set. This has led to greater liquidity in the form of generally tight bid/ask spreads and high trading volumes with significant participation by both local institutions and foreign investors.
The Size and Diversity of Emerging Markets Debt
Source: J.P. Morgan. Data as of 12/31/2017. Past performance is no guarantee of future results.
There are, however, complexities in emerging markets. Certain countries place limits, to varying degrees, on foreign investors’ ability to transact in their currency. The restrictions are often meant to reduce volatility in the form of “hot money” rapidly entering or leaving local markets. These countries have specific rules governing how bonds can be bought, sold, and delivered between two counterparties. An ETF may offer exposure to both restricted and non-restricted markets. For example, the VanEck Vectors®J.P. Morgan EM Local Currency Bond ETF (EMLC®) seeks to track the returns of the J.P. Morgan GBI-EM Global Core Index. Of the 19 markets included in this index, 15 markets are non-restricted and four markets are restricted.
One of the main differences between restricted and non-restricted markets in the context of ETFs relates to the “in-kind” trading mechanism. For non-restricted markets, bonds are normally delivered and received in-kind during the creation and redemption process, which means that there is no actual purchase or sale in the market by the ETF. Instead, bonds are delivered to or received by the authorized participant in exchange for shares of the ETF. For bonds denominated in restricted currencies, however, in-kind transactions are prohibited, and the ETF portfolio manager must buy or sell the bonds and execute the corresponding currency transaction in accordance with local rules.
Bonds in restricted markets are also custodied locally, and in certain countries are subject to withholding taxes on interest and/or capital gains. Bonds that are not custodied locally are typically not subject to these withholding taxes.
In light of these different market structures, relationships with local trading desks are often key to ensuring the maintenance of proper liquidity levels in certain markets. Traders typically reach out to multiple local dealers to find the best bond price and exchange rate in order to achieve best execution.
Real World Considerations
Unlike active portfolio managers who generally seek to beat their benchmark, passive portfolio managers are trying to match the benchmark as closely as possible, after fees and expenses. Because the benchmark index is not a traded security, the portfolio manager must take into account real-world considerations that are not reflected in the index, including operational, trading, tax, and cash flow factors. These factors can result in differences between portfolio and index returns, even in a portfolio that fully replicates its index. For example, the requirement to custody bonds locally in certain markets can result in higher safekeeping costs, which are not reflected in the index. Similarly, fixed income indices do not typically take withholding taxes into account.
Trading costs, such as bid-ask spreads, may also impact an ETF’s ability to track its index. Local sovereign bond markets have grown over the past several decades in both breadth and depth, resulting in generally high liquidity and tight bid-ask spreads. This allows the portfolio manager to more closely track the benchmark index without incurring significant trading costs. However, as mentioned earlier, certain restricted markets require cash transactions in both the currency and bond markets, resulting in higher trading costs versus markets where in-kind delivery is permitted.
The spreads in local bond markets, and the spreads in the local currency markets in the case of restricted markets, form the basis of primary market trading costs for a local emerging markets bond portfolio and therefore the costs of transacting in an ETF that invests in these markets. However, as ETFs grow and develop active secondary markets, spreads in the ETF are often significantly smaller than those in the primary markets in which the ETF invests. Although the ETF wrapper does not avoid withholding taxes or local custody requirements in certain markets, it may provide an efficient, low-cost and transparent way to access the underlying markets.
Putting It All Together
The varying market structures found within the emerging markets bond universe underscore a deeper truth – namely, that these markets may all be grouped into the same asset class umbrella, but each market is unique. Over the last decade, the size of the market has grown considerably, now presenting investors a tradeable market characterized by deep liquidity and tight spreads. The “one trade” access feature of ETFs allows an investor to gain access to multiple markets without having to jump through the operational and regulatory hoops necessary to trade in restricted markets around the world. For investors and allocators looking for low cost beta exposure to emerging markets local currency bonds, ETFs may offer an attractive solution.
IMPORTANT DEFINITIONS AND DISCLOSURES
J.P. Morgan GBI-EM Global Core Index tracks bonds issued by emerging markets governments and denominated in the local currency of the issuer, and are accessible by most international investors.
The indices listed are unmanaged indices and do not reflect the payment of transaction costs, advisory fees, or expenses that are associated with an investment in any underlying exchange-traded funds. Certain indices may take into account withholding taxes. Index performance is not illustrative of fund performance. Indices are not securities in which an investment can be made.
An investment in the VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (EMLC) may be subject to risks which include, among others, foreign securities, investing in Asian, European, Latin American and emerging market issuers, foreign currency, credit, interest rate, high yield securities, sovereign bond, cash transactions, market, operational, sampling, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, fund shares trading, premium/discount and liquidity of fund shares, issuer-specific changes, non-diversified and concentration risks, all of which may adversely affect the Fund.
The information herein represents the opinion of the author(s), but not necessarily those of VanEck, and these opinions may change at any time and from time to time. Non-VanEck proprietary information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Not intended to be a forecast of future events, a guarantee of future results or investment advice. Historical performance is not indicative of future results. Current data may differ from data quoted. Any graphs shown herein are for illustrative purposes only. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of VanEck.
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An investment in the Fund may be subject to risk which include, among others, Emerging Market Issuers, high yield securities, credit, interest rate, sovereign bond, foreign securities, foreign currency, issuer-specific changes, market, sampling, index tracking, replication management, cash transactions, authorized participant concentration, no guarantee of active trading market, trading issues, Fund Shares Trading, Premium/Discount Risk and Liquidity Risk of Fund Shares, non-diversified, and concentration risks , all of which may adversely affect the Fund. High yield bonds may be subject to greater risk of loss of income and principal and are likely to be more sensitive to adverse economic changes than higher rated securities. International investing involves additional risks which include greater market volatility, the availability of less reliable financial information, higher transactional and custody costs, taxation by foreign governments, decreased market liquidity and political instability. Changes in currency exchange rates may negatively impact the Fund's return. Investments in emerging markets securities are subject to elevated risks which include, among others, expropriation, confiscatory taxation, issues with repatriation of investment income, limitations of foreign ownership, political instability, armed conflict and social instability. The Fund's assets may be concentrated in a particular sector and may be subject to more risk than investments in a diverse group of sectors.
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