Surprising Kind of Junk Bonds Deliver Rising Rates Protection

It's not entirely accurate to say high-yield bonds are vulnerable to rising Treasury yields. After all, the widely followed Markit iBoxx USD Liquid High Yield Index is off just 0.14% year-to-date.

That's a lot better than the 3.08% shed by the Bloomberg Barclays U.S. Aggregate Bond Index and it's good news for advisors looking to bolster clients' income profiles and, these days, who's not looking to do that?

At the very least, the performance of the aforementioned high-yield bond index confirms that, despite rising Treasury yields, the overall case for bonds isn't dead. However, advisors can do better than just the standard domestic junk bond benchmarks when it comes to generating income and buffering against rising rates.

Believe it or not, emerging markets high debt can act as rising rates protection with a higher level of income. The VanEck Vectors Emerging Markets High Yield Bond ETF (NYSEARCA:HYEM) is modestly outperforming the Markit iBoxx USD Liquid High Yield Index year-to-date with a yield that's  more than 100 basis points ahead of the domestic gauge.

Reasons to Consider EM Junk

Perhaps unbeknownst to many clients that lack foundations in international bonds, emerging markets high-yield debt have been among the best-performing developing world debt since 10-year Treasury yields started soaring last August. However, there are other tangible benefits offered by the asset class.

“This segment of the market may also be relatively more insulated from higher local interest rates and fluctuations in the U.S. dollar, while the global exposure of many of the issuers allows the category to benefit from the spike in expected global growth rates this year,” says VanEck Head of Fixed Income ETF Portfolio Management Fran Rodilosso. “At the same time, emerging markets high yield corporates are one of the few areas where investors can still find yields that are still well above 5%.”

Obviously, it's reasonable to surmise that one of the reasons emerging markets junk corporates are proving durable in the face of rising U.S. rates is lower duration and that's true. The effective duration on the ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index HYEM's underlying benchmark – is 3.6 years. That's below the comparable metrics on broader baskets of emerging markets dollar-denominated and local currency debt as well as broader gauges of investment -grade corporates from issuers in developing economies.

“Further, the segment’s duration has remained close to where it was five years ago. The duration of USD emerging markets sovereigns, on the other hand, has extended significantly from about 6.7 five years ago, while the duration of broad emerging markets corporates was about 4.6 five years ago,” adds Rodilosso.

With EM Junk, There's a Spread Advantage, Too

Emerging markets high-yield corporate bonds also have higher average spreads, which is something for advisors to think about as rising Treasury yields compress domestic corporate debt spreads. These days, U.S. bond spreads are historically tight.

“However, emerging markets high yield corporates continue to provide a spread pickup of 135 basis points versus U.S. high yield corporate bonds,” notes Rodilosso. “Further, with what we view as expected strong global growth, continued accommodation by central banks and very benign credit conditions, it is difficult to identify a likely catalyst for widening out, particularly if the recent calmer tone in U.S. interest rates continues.”

Bottom line: Emerging markets junk bonds are unheralded rising rates play and for those that require more convincing, there's appreciation potential, too. Over the past three years, HYEM beat the Markit iBoxx USD Liquid High Yield Index by 350 basis points.

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