EMB Offers Investors An Interesting Play On Credit Risk With Mixed Durations
Summary The portfolio for EMB is heavy on bonds that are just barely investment grade. The maturity of those bonds is heavily diversified but the one empty part of the curve is short durations. A mixed duration on the bonds allows it to have a positive correlation with medium-term treasury ETFs. Despite the positive correlation with treasuries, it also has a positive correlation with the equity markets due to the credit risk exposure. The iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA: EMB ) is a very interesting option for investors wanting to add some new exposures to their portfolio. There are plenty of reasons for investors to be worried, but it remains an interesting allocation for a small part of the portfolio. Expense Ratio The expense ratio on EMB is .40% which feels like it would be typical for finding exposure to a somewhat niche market like investing in the bonds of emerging markets. That would probably be a fair assessment as well. While Vanguard also runs a fund in this niche market, the Vanguard Emerging Markets Government Bond Index Fund ETF (NASDAQ: VWOB ), the expense ratio in that fund is .34%. While there is a difference in the expense ratios, the difference is not very substantial. While EMB does have a higher expense ratio, it also has more than ten times the average volume with around 1.3 million shares per day changing hands compared to a hundred thousand for VWOB. Since shares of EMB are more expensive, adjusting for the difference in price would only extend the liquidity advantage of EMB. Credit Ratings The credit ratings on bonds in the portfolio can be seen below The majority of the bonds can be considered investment grade since the heaviest position is in the BBB rated bonds. However, it should be clear that there is still a substantial weighting to investments with lower credit ratings and this portfolio should be seen as being a fairly aggressive debt investment and share prices could be hit from factors as simple as an increase in the credit spread between riskier bonds and treasury securities. Maturity The following chart shows the maturities: This portfolio is incredibly diversified in the maturity of the securities. However, since the diversification includes a very material allocation over 20 years and very little at the shortest end of the yield curve it would be wise for investors to keep in mind that they are facing both substantial credit risk and duration risk. That makes this an interesting ETF for investors trying to optimize their portfolio for low volatility. Building the Portfolio This hypothetical portfolio has a slightly aggressive allocation for the middle aged investor. Only 30% of the total portfolio value is placed in bonds and a third of that bond allocation is given to emerging market bonds. However, another 10% of the portfolio is given to preferred shares and 10% is given to a minimum volatility fund that has proven to be fairly stable. Within the bond portfolio, the portion of bonds that are not from emerging markets are high quality medium term treasury securities that show a negative correlation to most equity assets. The result is a portfolio that is substantially less volatile than what most investors would build for themselves. For a younger investor with a high risk tolerance this may be significantly more conservative than they would need. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. (click to enlarge) A quick rundown of the portfolio The two bond funds in the portfolio are for higher yielding debt from emerging markets and (NYSEARCA: IEF ) for medium term treasury debt. IEF should be useful for the highly negative correlation it provides relative to the equity positions. EMB on the other hand is attempting to produce more current income with less duration risk by taking on some risk from investing in emerging markets. The position in (NYSEARCA: USMV ) offers investors substantially lower volatility with a beta of only .7 which makes the fund an excellent fit for many investors. It won’t climb as fast as the rest of the market, but it also does better at resisting drawdowns. It may not be “exciting”, but there are plenty of other areas to find “excitement” in life. Wondering if your retirement account is going to implode should not be a source of excitement. The position in (NYSEARCA: PKW ) makes the portfolio overweight on companies that are performing buybacks. The strategy has produced surprisingly solid returns over the sample period. I wouldn’t normally consider this as a necessary exposure for investors, but it seemed like an interesting one to include and with a very high correlation to SPY and similar levels of volatility it has little impact on the numbers for the rest of the portfolio. The core of the portfolio comes from simple exposure to the S&P 500 via (NYSEARCA: SPY ), though I would suggest that investors creating a new portfolio and not tied into an ETF for that large domestic position should consider the alternative by Vanguard (NYSEARCA: VOO ) which offers similar holdings and a lower expense ratio. I have yet to see any good argument for not using or another very similar fund as the core of a portfolio. In this piece I’m using SPY because some investors with a very long history of selling SPY may not want to trigger the capital gains tax on selling the position and thus choose to continue holding SPY rather than the alternatives with lower expense ratios. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of IEF’s heavy negative correlation, it receives a weighting of 20%. Since SPY is used as the core of the portfolio, it merits a weighting of 40%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the S&P 500 . Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. Conclusion When EMB is measured simply on the annualized volatility it does very fairly well. However, the difficult part about having mixed duration emerging market debt is that the poor credit rating encourages the portfolio to have a positive correlation with the market. If an investor is trying to minimize volatility they may be using a position in medium or long term treasury ETFs which would create some overlap on the long duration exposure but at very different credit ratings. Simply put, EMB manages to have positive correlation with both the market and with the treasury securities that have a negative correlation with the market. I like this bond space, however due to the strange situation with the correlations I would lean toward using it as a small portion of the portfolio. In this example I used it at 10%, but I suspect that 5% might be a more reasonable way to allocate it into the portfolio. Overall, you could say I find more things to like than dislike, but I would still limit the size of the exposure. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.