ETF Expert Corner

Van Eck’s Fran Rodilosso Spotlights New Emerging Markets Bond ETF

August 2nd, 2016 by ETF Store Staff

Fran Rodilosso, Portfolio Manager at Van Eck, spotlights the recently launched Vectors Emerging Markets Investment Grade USD Sovereign Bond ETF (IGEM) and discusses balancing risk versus return when investing in emerging market debt.



Transcript

You can listen to our interview with Fran Rodilosso by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: The ETF we're spotlighting this week is the VanEck Vectors Emerging Markets Investment Grade US Dollar Sovereign Bond ETF. The ticker symbol on that is IGEM. This just launched back in July. Joining us via phone from New York to discuss this ETF is Fran Rodilosso, Portfolio Manager for VanEck's Vectors Fixed Income ETFs. Fran, great to have you back on the program.

Fran Rodilosso: Thank you very much. It's great to be back on.

Nate Geraci: Fran, VanEck already has one of the most popular emerging market bond ETFs in the market, the Vectors JP Morgan Emerging Markets Local Currency Bond ETF, ticker symbol, EMLC. I'm curious, how does this new ETF differ from that one?

Fran Rodilosso: The main difference is, IGEM is a dollar denominated fund that tracks the index. Both IGEM and EMLC are focused on sovereign debt, but EMLC has the additional currency risk. With that, comes the higher yields that are offered in local markets. IGEM is focused on the dollar denominated debt from investment grade and double B rated emerging market countries.

Nate Geraci: Frank, can you talk a little bit about the underlying methodology for how IGEM selects the bonds in the portfolio?

Fran Rodilosso: IGEM tracks a JP Morgan index. JP Morgan is, for certain, the most followed indexer in the emerging markets that's based both in hard currency and local currency. They have a diversification method that tends to not fully market cap weight issuers. It keeps even the large market cap countries in the EM debt space typically below 10% percent of the weight of any index as happens in IGEM. The idea is to have a minimum of 80%, investment grade rated countries in the index, a maximum of 20% double B rated countries in the index. The reason for the double B component is, it still allows for a higher quality in terms of credit rating index overall versus the broad emerging market debt space, but you get an additional close to 50 basis points of yield for those higher rated sub investment grade issuers. It also adds diversification and liquidity to have that double B bucket. Countries like Russia and Brazil were downgraded last year to double B. They're big liquid issuers. Again, we can strain that double B bucket to no more than 20%. That's a key part of the index. At the end of the day, you have about 32 countries represented in the index that qualify, based on liquidity parameters and those ratings parameters, and they also need to be defined as emerging market issuers. They're also quasi-sovereign, and JP Morgan has a very strict definition of quasi-sovereign issuers, so they need to be fully owned or guaranteed by sovereign governments to be included in the index. That adds a number of other issuers and adds, again, to the diversification ability.

Nate Geraci: Frank, can you give us an idea as to some of the countries whose debt is held in this ETF?

Fran Rodilosso: Some of the larger weights in the index include Mexico, Indonesia, the Philippines, other countries that are significant. Those are the three largest weights. Brazil, Turkey, Colombia, South Africa, some with very positive fundamentals and positive news going on and some, obviously, Turkey's been in the headlines lately and Brazil. It contains the mix of emerging market debt risks, but, again, these are all double B rated and above countries. The countries you won't see are the likes, at this point in time, of Argentina or certainly Venezuela.

Nate Geraci: Fran, going back to your comment on currencies, from an investor's standpoint, what's the tradeoff between investing in local currency debt versus dollar denominated debt? What should investors be thinking about here? There are, obviously, ETFs in the market that do both including VanEck's own lineup.

Fran Rodilosso: There are several key factors. The majority of volatility in a local currency debt fund historically has been driven by the currency movements rather than the local interest rate movements. Ironically, this year, local interest rates have driven more of the positive return in the local currency space than have currency movements. Historically, the currency volatility is a key component. Generally speaking, in most environments and certainly today, if you're investing in a local currency space, you have currency risk and local interest rate risk. Those local interest rates are far higher on average than develop market rates or than the dollar denominated debt yield even for emerging market countries. Similarly rated index that our EMLC tracks yields in the mid-sixes on average with some countries yielding still over 10%, such as Brazil. In exchange for that, you are taking a currency risk. Those EM currencies are going to correlate more with commodities markets and global growth numbers than they are necessarily with US rates. When you're investing in a dollar denominated fund, you're going to be more sensitive to US interest rates. You're not going to be taking on that currency risk, but you are going to have lower yields on the order of about 250 basis points for 2.5% lower average yield in your portfolio today when you're investing in that dollar denominated debt.

Nate Geraci: Before we move on here, because I do want to talk more generally about the challenge investors face investing in fixed income right now, what's your general assessment of emerging market debt? What are some potential positive catalysts here?

Fran Rodilosso: We had some this year. An important fundamental dynamic for emerging markets overall, and certainly for their ability to pay debts, is the global growth picture. The rebound year-to-date in commodity markets has been an important factor in improving, for some markets particularly, those commodity exporting countries out of, say, Latin America and parts of Eastern Europe and even Africa. Global growth, particularly for some of the Asian markets, is also incredibly important. What we've had this year though is also more tepid global growth, but we've actually had a turn in emerging market fundamentals relative to developed market fundamentals. In other words, emerging markets have started to increase their projected growth advantage over developed markets. Emerging markets are expected to grow by a couple percent more than developed markets in 2017, for instance. That gap had narrowed, that growth gap had been narrowing for a couple of years. Also, emerging markets had some poor performance, particularly on the currency side, for a couple years, expectations of higher US rates, a stronger US dollar, and lower commodity prices. The Fed being on hold this year, it's an important technical aspect, but it has put either a stall or end to the dollar rally. That's been important for the strength of some EM currencies. Emerging markets also were running large, certain emerging markets, were running large current account deficits several years ago which meant they needed to borrow money basically in order to fund those deficits, borrow money internationally. Being emerging markets, their currencies reacted very negatively. That's why local currency debt did not do well for several years leading into 2016. Those currency movements, the currency weakness for those several years, actually helped correct those current account deficits. You've seen emerging market fundamentals start to improve from a current account point of view, from an overall growth point of view. All at the margin, particularly on the growth front, there's still a lot to be said. Most emerging market investors are less concerned about a slow or controlled rise in global interest rates because that would mean we're in a positive growth environment. The key fundamental for EM, and for all debt repayment ultimately, is growth.

Jason Lank: Fran, this is Jason Lank. Appreciate you being back on the show. I wanted to ask you a question about fund flows as investors search for yield in today's low return environment. Certainly they're finding emerging market investments, we've seen that because of the fund flows. How deep are these markets? Most investors probably didn't know they could invest in emerging market sovereign bonds so easily with a product like this. If the world discovers this opportunity and the money starts gushing in, are there any problems associated with that?

Fran Rodilosso: Very good question. The dollar denominated sovereign debt market has been something even smaller investors, on some level, have had access to for more than twenty years. That market is deep, the larger index have market caps and indexes have market caps anywhere between five hundred billion and a trillion US dollar equivalent. It's something equivalent to US corporate credit market, particularly for the investment grade sovereign issuers, maybe closer to the higher quality end of US high yield in terms of liquidity and depth. It's been perceived as a similar market to that. Obviously, there's a lot more money invested in both the ETF and mutual fund space in, say, US high yield, than there is in emerging market debt. There's capacity. Interestingly, the local currency markets, although, again, with the currency risk, it carries additional risks to investors, is much deeper than the dollar denominated market. It's a five plus trillion dollar market globally, but the indexes tend to hold somewhere between eight hundred billion and a trillion US, but those markets have greater depth beyond that. It's also interesting because most of the local currency debt that emerging market countries have issued is actually held locally. It decreases the flow internationally, but it increases the liquidity in some ways. There are natural holders, insurance companies in Asia, pension funds in Latin America. They play a very important dynamic in the markets and they behave, in no way, exactly like US treasuries, but in the local sense, these are treasury markets. The countries are interested in developing yield curves and having liquidity and functioning markets. The local currency EM debt, particularly at its total level of investment that's lower than the hard currency market, has a lot more capacity, but both markets can handle increased flows for some time. Despite the inflows this year, remember, we've seen mostly outflows, particularly from retail investors for the last several years, definitely 2014 and 2015.

Nate Geraci: Again, we're visiting with Fran Rodilosso, Portfolio Manager for VanEck's Vectors Fixed Income ETFs. Fran, with interest rates so low all across the globe, and some twelve to thirteen trillion dollars in negative yielding bonds, Jason and I have said that generating income might be the single greatest challenge facing investors today. We talked about how it used to be you could just stroll down to your local bank, ladder some CDs, and probably have a decent stream of income, but that's simply not the case anymore. It's certainly a real challenge for investors trying to find yield right now. How do you think investors should approach income generation in this environment? How do you balance risk versus reward?

Fran Rodilosso: I think central banks, particularly develop market central banks, have put us in quite a quandary. They'd like to encourage risk taking, but it does put portfolio managers and investors, particularly later stage investors, in a somewhat precarious position of, "How do you attain more yield in your portfolio, particularly if you're not in a position to dip into principal?" Traditionally, yield has always come in several ways. One is higher risks or lower rated investments, another way is lower liquidity. For many investors, they have to consider those risks. Certainly, if you're talking about emerging market dollar debt, that's one set of risks that's external debt from emerging market countries. They can't repay that in their own currencies so that has higher credit risk in some ways. Local currency debt has, in some ways, lower credit risk, but higher currency risk. In general terms, investors have to think about diversification. It's such a simple word, such a simple concept in many ways, but there is not one yield solution because you are moving out the risk curve, or the liquidity curve, in general when you are trying to find pockets of yield. There are many solutions out there, there are preferred securities, there are MLPs, there's US high yield debt, global high yield, emerging markets. My feeling is, you want to be careful about not counting on a single solution. You want to use the fact that you have all these tools at your disposal to diversify your exposure to risk as you're going for yield. Then, try to understand what drives the dynamics of some of these asset classes. We talk about commodities and that's going to be more important actually for EM local debt, Treasury yields, and whether or not the Fed starts moving more rapidly than expected, can impact different asset classes in different ways. Diversification is still one of the best risk management tools out there.

Nate Geraci: Fran, with that, we'll have to leave it there. Certainly, a pleasure having you back on the program. Great insight into emerging market and emerging market debt. We certainly appreciate your time today. Thank you.

Fran Rodilosso: Thank you for having me. I really appreciate it.

Nate Geraci: That was Fran Rodilosso, Portfolio Manager for VanEck's Vectors Fixed Income ETFs. You can learn more about the entire Vectors ETF lineup by visiting vaneck.com.