High Yields Abroad Draw a Crowd

10/25/2010 1:30 pm EST


Paul Justice

Associate Director of North American ETF Research, Morningstar, Inc.

Paul Justice, Morningstar’s director of North American ETF research, and analyst Timothy Strauts suggest an income ETF that should rise with the stronger currencies.

The WisdomTree Emerging Markets Local Debt ETF (NYSE: ELD) is one of the first funds to give investors access to local-currency emerging-markets bonds. With all the concerns about rising debt in the developed markets, investors are increasingly looking to emerging countries for their high growth rates and low comparative debt levels.

Emerging markets have traditionally relied on developed countries for demand and financing, but those dynamics have shifted during the last 12 years. Furthermore, an emerging middle class has been creating strong domestic economic growth in these countries, which should bolster a healthy and sustainable rise of sovereign wealth in each. This has allowed emerging countries to maintain sound fiscal policies, more flexible currencies, a higher savings rate, and a growing private pension system.

We like this fundamental story, but we are also aware of the tremendous amount of assets that have been flowing into this sector in 2010. This has created strong momentum that could propel returns higher in the short term but could also create an overvalued asset class as investors continue to flock to income investments.

ELD owns local-currency bonds, so foreign-currency movements will affect the value of the fund dramatically. If the emerging markets continue growing their economies faster than does the United States, their currency should rise versus the dollar, which will be positive for ELD.

With the sovereign-debt crisis in Europe, investors are re-evaluating which countries are most creditworthy. The developed world has good credit ratings and very high debt levels. The emerging world has lower credit ratings and low debt levels. There is growing belief that, despite emerging markets’ lower credit ratings, they may actually be better credit risks.

The threat of higher interest rates is always a concern, but the fund’s relatively low duration (a measure of interest-rate sensitivity) of 4.0 years helps mitigate that risk. High unemployment will probably delay the Federal Reserve from meaningfully raising interest rates until 2011 or 2012. Also, if inflation increases, as many have predicted, that will be another negative on fund returns.

The fund is active and does not follow an index. It invests in sovereign bonds in as many as 14 emerging-markets countries. The credit quality of the portfolio is A-.

Income received will be taxed as ordinary income. However, some foreign countries impose withholding and other taxes on distributions. This may entitle investors to take a tax deduction on the amount of the distribution withheld.

ELD implements a tiering strategy that attempts to put more assets in countries that maintain strong fiscal discipline. There are four countries in tier one, each getting an 11.1% weighting; five countries in tier two, each getting a 7.4% weighting; and five countries in tier three, each getting a 3.7% weighting. The countries currently in tier one are Indonesia, Brazil, Mexico, and Malaysia. This strategy should increase the average credit quality of the fund because more assets will go into the highest-quality countries.

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