When you're investing in today's tumultuous markets, you have to be able to use all the available tools to succeed. Emerging market debt ETFs are another tool you should consider adding to your workbench.
The ETF choices
Emerging market debt ETFs come in two varieties. Some, including iShares JPMorgan USD Emerging Markets Bond (NYSE: EMB ) and PowerShares Emerging Markets Sovereign Debt (NYSE: PCY ) , own foreign-issued bonds that are denominated in U.S. dollars. Others, such as WisdomTree Emerging Markets Local Debt (NYSE: ELD ) and Market Vectors Emerging Markets Local Currency Bond (NYSE: EMLC ) , own foreign-currency denominated bonds.
This is an important distinction for potential investors. As we'll see below, each comes with its own specific risks and rewards.
Advantages of emerging market debt ETFs
By now, your financial advisor has probably bludgeoned you to death with the importance of diversifying your portfolio. Emerging market bond ETFs can offer further portfolio diversification. These ETFs often zig and zag in different directions from stocks and other types of bonds.
That said, the zigs and zags are sometimes pretty volatile, especially with the market uncertainty we've seen lately. But the rewards have been significant; the iShares ETF is up more than 50% in the past two years, while the PowerShares ETF has risen 75%.
Given the difficulty of buying these bonds directly, ETFs are a nice vehicle to gain access to high yields at relatively low costs. As you'd expect, the yields on these bond funds are higher than you'd see with the emerging market stock ETFs iShares MSCI Emerging Markets Index (NYSE: EEM ) and Vanguard Emerging Markets (NYSE: VWO ) . But they have similar expense ratios.
Risks
Emerging market debt ETFs may seem tempting, but potential investors have to be aware of a few important risks as well.
Sovereign bonds denominated in foreign currencies carry exchange rate risk. Investors holding these assets can gain or lose money based on changes in the exchange rate as well as changes in the value of the bonds themselves. While this can supercharge your profits should the foreign currency appreciate against the dollar, on the flip side, it can lead to huge losses. Conversely, U.S.-dollar-denominated bonds don't have the same currency risk, but they can cause greater default risk since a country can't simply devalue its currency to pay off its debt.
In addition, bonds carry political risk, as a country may decide to achieve a particular economic goal by influencing its currency or choosing to default on its debt. So investors in emerging market debt ETFs need to keep an eye on political conditions abroad.
Conclusion
Emerging market bond ETFs certainly are an interesting breed that's capable of adding some spice to your portfolio. The thought of adding them to your holdings is exciting as they are capable of large profits combined with high yields and low expense ratios. However, investors need to be aware of the pitfalls and should carefully consider whether they are worth the risk to achieve their financial objectives.
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