Update: iShares J.P. Morgan $ Emerging Markets Bond UCITS ETF

Europe-based investors considering this ETF should take into account a fair array of risk considerations including: currency, country and duration. This ETF is a USD-denominated monthly-dividend-distributing vehicle; hence foreign exchange considerations are to have a regular impact on the expected income stream. As per country risk, the ETF does not discriminate between geographical areas; thus making it a good vehicle for those wanting to maximise diversification, but a poor one for those wanting to target a specific area or country. Finally, this ETF has a relatively high modified duration (e.g. around 7%). This is reflective of the still generally long-term maturity bias of emerging market issuing governments. However, closely interlinked with currency exposure, it adds a further layer of performance risk ultimately dependant on US monetary policy moves. The long duration of this ETF makes it vulnerable to proportionally higher capital losses when the Federal Reserve raises interest rates.

Fundamentale Analyse 

Emerging markets (EM) are routinely described as one of the main financial markets success stories of the last two decades. Structural changes to the way these economies are governed have facilitated large capital inflows, in turn leading to a significant shift in international investors’ asset allocation trends. EM exposure is now part and parcel of most investment portfolios, with investors lured by comparatively high returns and a perception of diminished risk. 

USD-denominated EM government bonds have rebounded from the dip experienced in 2013, with the USD strengthening a key driver. However, macro risks not only remain in place, as EM economic growth continues to slow, but in some cases they have intensified. Indeed, besides geopolitics and internal social dynamics, a number of emerging market economies (e.g. Russia, Brazil) are being negatively affected by the collapse in commodities prices, particularly oil. Adding to these worries, EM bond valuations may be negatively affected by the eventual normalisation of US monetary policy. 

In a way, the global economic crisis has exposed one of the key weakness of the rationale for investing in EM. The success of a large number of these economies has been predicated on an export-oriented model whereby they became the suppliers of choice to consumption-driven developed partners. As the latter struggled, EM economies looked to incentivise internal sources of growth. In many cases, their efforts fell short of expectations. The end result was a significant slowdown in economic growth. All the while, the energy revolution in places such as the US, has placed non-diversified oil-exporting EM economies in a perilous position.

Going forward, any move by EM economies to address the economic slowdown by boosting domestic demand via higher government expenditure could weigh on EM government bond valuations. As a whole, EM may remain an interesting asset class. However, investors would need to discriminate against the group of more resilient countries within the group, which tend to be characterised by sizeable current account surpluses and foreign reserves.

Despite the growing importance of local currency-denominated EM bond markets, a significant share of EM government bond issuance is still conducted in USD. As such, investors also need to consider the impact that US monetary policy decisions may have on performance. As we write (early February 2015) the focus is on whether the US Fed may start to hike interest rates before year-end or would instead wait until early 2016. Irrespective of timing, policy normalisation, would be USD-supportive.

Indexkonstruktion

The JP Morgan EMBI Global Core Index is a subset of the broader JP Morgan EMBI Global Index and measures the performance of most liquid USD-denominated emerging market sovereign or quasi-sovereign bonds. The EMBI Global Core Index includes fixed, floating rate and capitalising bonds with a minimum outstanding of USD 1bn and minimum remaining maturity of 2.5 years. Eligible countries are those classed by the World Bank as having low or medium per capita income for two consecutive years, or countries that have restructured their external debt over the last decade. The index is calculated every business day of the year, as defined by the US bond market calendar. Valuations are calculated on best offer/bid prices submitted by a selected group of emerging market brokers or JP Morgan traders if prices from selected brokers are not available. This is a diversified index which limits the weights of countries with higher debt outstanding. The index is rebalanced on the last business day of each month. Income arising from coupon payments is reinvested in the index on the date paid.

Fondskonstruktion

iShares uses physical replication to track the performance of the JP Morgan EMBI Global Core Index. Given the large number of index constituents, iShares uses stratified sampling to construct the fund. The index is broken down into sections, each representing key risk factors (e.g. duration, currency, country, rating). The managers then choose bonds that mimic the risk profile of each section. The aggregate result is a portfolio that represents the index’s overall risk profile, while allowing the ETF manager to avoid purchasing bonds that may suffer from illiquidity. This ETF distributes dividends on a monthly basis. As we write (early February 2015) the number of fund constituents was 276, with Turkey, Philippines, Mexico, Indonesia, Brazil and Russia as the top six issuers in value terms (e.g. 30-35% of the fund’s basket). The fund’s modified duration is in the 7-8 year range, in keeping with the benchmark. iShares engages in securities lending in order to optimise the ETF’s tracking performance. BlackRock acts as investment manager on behalf of iShares. The amount of securities that can be lent out is capped to 50% per fund. The annual average on loan for this ETF in the year ending in December 2014 was 13.5%. Lending operations are hedged by taking UCITS-approved collateral greater than the loan value and by revaluing loans and collateral on a daily basis. The collateral is held in a ringfenced account by a third party custodian. The degree of overcollateralisation is a function of the assets provided as collateral, but typically ranges from 102.5% to 112%. Lending revenue is split 62.5/38.5 between the ETF and BlackRock, respectively.

Gebühren

The total annual expense ratio (TER) for this ETF is 0.45%. This sits mid-way in the 0.30-0.55% TER range for ETFs providing exposure to the USD-denominated segment of the EM government debt market. Additional costs potentially borne by investors and not included in the TER include bid/offer spreads and brokerage fees when buy/sell orders are placed for ETF shares. There are also rebalancing costs whenever the index changes composition.

Alternativen 

The iShares JP Morgan USD EM Bond ETF is European market leader in this particular segment, as measured by AUM. Amongst its competitors, we find the db x-trackers II EM Liquid EuroBond ETF. Using synthetic replication, the db x-trackers ETF carries a higher TER of 0.55% and its returns are hedged in EUR, which may be seen as an advantage for investors – particularly Eurozone-based - unwilling or unable to deal with FX considerations. It is worth noting that iShares launched a EUR-hedged version of the JP Morgan EM Bond ETF in 2013. 

Another alternative is the Amundi Global Emerging Bond Markit iBoxx ETF, a USD-denominated fund charging a TER of 0.30%. Despite a more competitive TER, its AUM remain a fraction of those held by iShares and also lag behind the db x-trackers ETF.

Investors also have access to ETFs providing exposure to local currency EM government debt, which tends to be issued mostly in short-to-medium maturities. The SPDR Barclays Capital EM Local Bond ETF (TER 0.55%), the iShares Barclays Capital EM Local Government Bond (TER 0.50%) and the PIMCO Source Advantage Local Bond ETF (TER 0.60%) offer this exposure. They all are physically replicated.