EMB is an index fund that invests in bonds issued by governments and businesses located in the emerging markets. An income stream of about 3.8% annual yield is distributed to shareholders in monthly payments. Exposure to EMB’s portfolio incurs the risks of geographic region, bond market fluctuation, and portfolio management. EMB holds a riskier portfolio than the bond index fund AGG.
About the Index
The underlying index tracks the total return of fixed-rate and floating-rate bonds issued by governments and corporations in approximately 31 countries tagged as the emerging markets. The bonds are U.S. dollar denominated and non-convertible. The index is market-value weighted and rebalanced every month.
About the Fund
Strategy. EMB’s objective is to match the performance of the Index before deduction of administrative costs, which are about 0.6% of the net asset value. EMB’s strategy is to invest at least 90% of assets in securities of the underlying index by selecting a representative sample of the Index. The fund may occasionally invest up to 20% of assets in various derivatives and cash-equivalent assets.
Tracking error. Since inception the average annual total return of the fund’s net asset value underperformed the Index by a difference of 0.81 percentage points. The cumulative net asset value underperformed the Index by a difference of 4.68 percentage points.
- Issuers may not pay the interest or repay the principal, especially if the bond is rated below investment grade. About 54% of EMB’s bonds are rated below investment grade.
- Bonds with longer maturity dates are more susceptible to loss of value from an increase in interest rate.
- Issuers of callable bonds may repay the lender before maturity when the interest rates are declining. The Fund may lose income by necessity of reinvesting the principal at a lower interest rate.
Price history. The following chart shows that EMB’s share price (thick blue line) increased by 17.7% compared to AGG’s (thin purple line) 7.3% climb during the past 5 years.
The bond-buying program of central banks reduced the interest rates of government bonds, thus reducing the interest earned from investment grade bonds. The reduced interest rates pushed bond prices up and bond yields down. Today’s (1/30/2013) high bond prices are vulnerable to decreasing when the interest rates start to climb (i.e., interest rate risk). The same reasoning applies to an increase in the bond funds’ weighted average coupon and effective duration.1 Ways of managing interest rate risk include
- selling bonds now and venturing into other assets such as stocks.
- reducing the effective duration of a bond portfolio
- investing in high-yield corporate bonds and emerging-market government bonds
Emerging markets generate 40% of the global GDP and have only 10% sovereign debt, making it a good bet that emerging markets have enough revenue for debt service.1 From a survey of 141 emerging-market banks, results indicate that lending conditions are improving in the emerging markets despite a declining demand for commercial real estate loans and a growing number of non-performing loans.2,3
Copyright © 2013 Douglas R. Knight
1. Joe Light. The risk of safety. The Wall Street Journal, 1/25/2013.
2. Sudeep Reddy. Emerging-market loan view perks up. The Wall Street Journal, 1/29/2013.
3. Emerging Markets Bank Lending Conditions Survey – 2012Q4. IIF, Institute of International Finance.