Safety and higher yield can co-exist

Posted on: August 1, 2011 in: Emerging Markets, Fixed Income with 0 comments

BMO Emerging Markets Bond Hedged to CAD Index ( Ticker: ZEF )

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It is finally here – The Big Showdown Weekend. Either U.S. legislators agree to raise the debt ceiling, or else, come Tuesday, the U.S. Treasury stops paying some of its bills on time and U.S.  bond prices fall as interest rates shoot up. Things are no better in the Euro-zone. Fresh loans and restructured debts postponed the Greek dilemma but the durability of the Euro currency is in question.

Safety-seeking investors are buying gold, the Swiss Franc, even, strangely, U.S. Treasuries with near-zero yields, though they are opting for post-August maturities, expecting any default to be brief.

Another alternative is emerging market bonds, both sovereign and corporate. Their much higher yields and relative safety are attracting investors, especially in the United States. In Canada, demand is still nascent.

Emerging markets have fared well since the Great Recession of 2008. They were in better shape going in. Many like Indonesia, Malaysia, Brazil and of course, China had piled up cash reserves from years of strong exports. Many, having survived the Asian financial crisis of 1998, already had stricter rules governing banks and financial derivatives like mortgage-backed securities.

When the recession hit, healthy doses of fiscal stimulus supported economic growth. So much that most emerging markets have been raising their interest rates since last year trying to keep things from overheating. For two reasons, that is good news for bond investors.

First, the average emerging market bond yield is nearly double that of a Canadian or U.S. Treasury.  Brazil and Mexico 10-year Treasuries both yield over 6%. South Africa yields over 8%. China, Korea and Indonesia are in the 4% range.

Credit raters put emerging markets at below Canada and the United States but that does not necessarily reflect their ability to honor their obligations. I truly hope the United States can say as much on Tuesday. And remember, these are the same agencies that, a few years ago, with their magic wands, turned worthless mortgages into AAA securities, but just until midnight.

Second, with emerging market interest rates already high, further increases will be smaller, limiting the threat to the bond prices, which move inversely to rates. In Canada and the United States, future rate increases are a given so bond prices are sure to fall.

There are several emerging market bond ETFs to choose from. The biggest, with nearly $3 billion in assets, is the iShares JPMorgan USD Emerging Markets Bond ETF (EMB-NY). However, being foreign, it does not get favorable tax treatment in Canadian accounts.

Instead, consider the BMO Emerging Markets Bond Hedged to CAD Index ETF (ZEF-TO). It holds 21 sovereign bonds issued in U.S. dollars by countries like Mexico, Brazil, Russia and Korea. It has a duration (a metric that combines a bond’s term to maturity with the present value of its coupons) of 7.3 years, which makes it less sensitive to interest rate changes than bonds of longer duration. It currently pays about 7.2 cents each month, giving it a current yield of about 5.3%.

ZEF hedges its U.S. dollar exposure back to the Loonie. Instead, I would prefer if it offered exposure to emerging market currencies, given those should appreciate over time. The Economist magazine, in its Big Mac Index, compares burger prices across countries. A burger in, say, Jakarta, costs $2.53 versus $4.75 in Toronto. The difference comes from input costs, especially labor. As countries develop, costs converge and eventually, the burgers cost about the same. In the process, the Rupiah strengthens against the Loonie and the Indonesian bond buys as many burgers in Toronto as it does at home, which is to say, a lot.

ZEF’s other disadvantage is its size. Launched in May 2010, it has just $23.6 million in assets. Its trading volumes are low, usually no more than $150,000 a day. Keep that in mind when you size and place your trade.

Disclosure: We may hold positions in any or all of the securities mentioned in this report.

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archerETF Metrix ZEF
Category EM Fixed Income
Benchmark Barcap EM USD Bond Index
Total Holdings 21
52 Week High $16.28
Recent Price $16.28
52 Week Low $15.10
Avg Daily Volume 9,000 Shrs
Avg Daily Volume ($) $0.15 Million
Total Market Cap $23.60 Million
ETF Annual Fee 0.50%
ETF Trading Currency CAD
ETF FX Exposure USD Hedged to CAD
Annual Volatility Not Available
Correlation to TSX Composite 51.2%
Return to Risk Ratio Not Available
Use of Leverage No
Use of Futures No
6 month Return 4.43%
1 Year Return 7.81%
2 Year Return Not Available
3 Year Return Not Available
Dividend Yield (TTM) 5.34%

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© 2011 archerETF Portfolio Management is a division of Bellwether Investment Management, a discretionary portfolio manager registered with the Ontario Securities Commission. This report is provided for information only and does not constitute investment advice. While we believe the information to be accurate and timely, we make no claim or warranty to that effect. Please seek professional advice before making any investment decision. We may hold positions in any or all securities discussed in this report.

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