Rebel Against That Western Bias

 | May 23, 2012 | 11:30 AM EDT
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I recently fielded an interesting question from a friend looking to diversify a fixed-income portfolio beyond U.S. borders. He'd zeroed in on iShares S&P/Citigroup 1-3 Year (ISHG) as a potential way to expand geographically and capture a bit of additional yield in the process. So I felt a need to set him straight and direct him towards much more attractive opportunities in the international bond space.

There are a handful of bond ETFs out there that offer exposure to portfolios comprising debt from heavily indebted Japan and the struggling eurozone. Allocations to these types of products makes no sense to me, especially when emerging-market debt stands out as an alternative, offering higher returns and lower risk and volatility. It's helpful to compare ISHG, which offers exposure to short-term debt of developed markets outside the U.S., to iShares J.P. Morgan USD Emerging Markets Bond Fund (EMB), which holds debt from emerging-markets issuers. Across the board, EMB is more appealing to investors:

Currency Risk

ISHG holds debt that is denominated in the local currency of issuers. That means owning ISHG would involve taking on exposure to the Japanese yen, which Tokyo has been furiously trying to depress, and to the euro, which has its own well-chronicled challenges. That's not exactly an appealing combination, especially in the current environment.

EMB, though it holds debt of emerging-markets issuers, consists entirely of holdings denominated in U.S. dollars. In other words, there's no risk or opportunity related to exchange-rate movements here (at least not directly). EMB won't be impacted by currency fluctuations.


In regard to 30-day SEC yields, a standardized metric used to make apples-to-apples yield comparisons, ISHG currently has a figure of 1%; EMB sports one of 4.4%. Part of that gap is explained by the difference in effective duration -- about seven years for EMB compared with just 1.8 years for ISHG. However, the interest rate risk alone doesn't account for the entire disconnect. In my mind, the rest is pure opportunity -- EMB offers a ton of opportunity with limited risk, while ISHG offers almost nothing in the way of return while exposing investors to significant risk factors.

Credit Risk

For some reason, U.S.-based investors remain stuck in the mindset that emerging markets are inherently more risky than developed economies are. The concept of investing in emerging-markets debt seems like a highly speculative exercise, and that's because we have become biased by tales of nationalized oil companies and corrupt dictators. That's huge disconnect from the economic reality: Emerging markets generally boast fiscal strength and creditworthiness that is the envy of the developed world.

The proof is in the recent performance. EMB has a lower 200-day volatility than does ISHG, even despite the fact that it has a significantly higher duration and holds debt of emerging-markets issuers that are generally assumed to be greater credit risks.

I'm not sure about you, but I'd rather hold debt issued by China or India than by Spain or Italy.

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