Default Contagion Out of Emerging Markets Could Take Down This ETF

November 8, 2019 | Liquid Alternatives, News

The iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) has had a dream run so far, but it may be time to cash in.

An article by Harrison Schwartz in Seeking Alpha makes a case for divesting holdings in the EMB ETF or even going short on it. The main risk: A default contagion emanating from emerging markets on unsustainable dollar-denominated debt.

Why investors may be loath to divest EMB

The iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) pays a dividend of 5.5%. The ETF generates income from holdings in dollar-denominated bonds of more than 30 emerging market (EM) countries. Since 2010, the yield on the ETF has averaged around 6%.

“EM bond funds like (EMB) seem like a free lunch,” says the author. “They offer equity-like returns and have had far less volatility than equities.”

EMB: Lurking risks from emerging market debt

According to the author, an analysis reveals that most of the helicopter money issued post-crisis in the name of Quantitative Easing (QE) has found refuge in emerging markets as an investment in their debt.

Had this money remained inside Japan, Europe, and the US, where it originated, it would have fuelled rampant inflation. Instead, the developed markets exported this inflation out to emerging markets.

As a result, EMs are reeling under a debt overload, high inflation, and currency depreciation. The depreciation in currencies makes it even more difficult to service foreign debt.

The inflation has crimped citizens’ income raising the specter of protests and revolt. Raising taxes to pay for servicing the debt will inflame emotions further in EM countries.

Hedge fund titan Ray Dalio has also expressed his worries about this scenario.

Vicious cycle

In these situations, EM debt, even sovereign, could be ripe for default.

The EMB ETF has less than half of its assets in less than investment-grade bonds and over 75% in BBB and below rated debt. It is, therefore, vulnerable to worsening economic conditions.

A bond sell-off in EMs could trigger a vicious cycle of rising interest rates, weakening currencies, hyperinflation, deteriorating ratings and so on.

“For me, EMB and funds like it are clear sells,” says the author. “A yield of 5.5% is simply not worth the risk of a 30-40% drop.”

[Related Story: Ray Dalio Thinks the World Has Gone Mad ]

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