Relative to U.S. bonds, U.S. dollar-denominated emerging-markets bonds are more volatile, and therefore may not be suitable for those who use their fixed-income allocation as portfolio ballast. During the last three years, the standard deviation of monthly returns for the Barclays U.S. Aggregate Bond Index was 2.8% versus 7.4% for the J.P. Morgan EMBI. Emerging-markets bonds have enjoyed an uptick in interest among foreign investors during the last few years, given issuers' relatively healthy fundamentals and higher yields. As a result, the asset class is now more sensitive to developments in the global macroeconomic environment and fund flows from overseas. A spike in global volatility or deteriorating fundamentals in emerging markets can quickly trigger sudden portfolio outflows. Capital flight will negatively impact the short-term performance of emerging-markets bonds and this ETF.

Fundamental View

Emerging-markets credit profiles have improved significantly during the last 20 years. After the crises of the 1990s in Latin America, Asia, and Russia, many countries implemented sound fiscal and monetary policies and now have average debt/GDP levels that are lower than those within the developed world. Other positive trends include a stable growth outlook, high levels of foreign reserves, greater central bank independence, and flexible currency regimes.
The sovereign debt crisis in Europe and aggressive quantitative easing in the U.S. and other developed nations have led some investors to re-evaluate the creditworthiness of these countries. Many developed nations continue to sport solid credit ratings despite having lofty debt levels and anemic growth. Meanwhile, many emerging markets still have relatively lower credit ratings despite the fact that they have relatively low debt levels and comparatively better growth prospects. There is growing belief that, despite emerging-markets sovereigns' lower credit ratings, they may actually be better long-term credit risks. So while the funds' average credit ratings are borderline investment-grade, the actual credit risk of these funds' constituents may actually be better than what their ratings suggest.

Thanks to improving fundamentals and relatively higher yields in emerging markets, demand for emerging-markets debt has skyrocketed during the last few years. In the five years leading up to the 2008 financial crisis, flows into U.S.-listed emerging-markets debt funds (which include both mutual funds and ETFs) averaged around $1 billion a year. In 2010 and 2011, this figure jumped to $15 billion a year, followed by a record $28 billion in 2012. Strong growth in supply (new bond issuance) and demand (rising allocations) are positive long-term trends for emerging-markets issuers. However, the downside to these trends is that emerging-markets bonds are now more susceptible to global sentiment. In 2013, concerns about the impact of the tapering of the U.S. Federal Reserve's asset-purchase program on the emerging markets resulted in a flare-up in volatility and average declines of 7% across emerging-markets bond funds in 2013.

As is the case with all bond funds, rising interest rates are a risk to these ETFs. The portfolio duration (a measure of interest-rate sensitivity) of PCY and EMB as of this writing is nine and seven years, respectively, which is higher than the Barclays U.S. Aggregate Bond Index's five years.

Portfolio Construction

PCY tracks the DB Emerging Market USD Liquid Balanced Index. This rules-based, enhanced index includes about 60 U.S. dollar sovereign bonds from 22 emerging-markets nations. The index selects one to three liquid bonds from each country that are likely to generate excess return relative to bonds with similar attributes. Securities are weighted to achieve equal weighting across countries. Unlike market-cap-weighted emerging-markets equity indexes, hard-currency emerging-markets bond indexes do not have very large country concentration. The five largest countries represented in the portfolio account for 25% of its assets (with each country accounting for about 5%), while the top 10 countries account for half. Distributions are paid monthly. This fund carries an annual fee of 0.50%.

EMB tracks the J.P. Morgan EMBI Global Core Index. This index reflects the total return of U.S. dollar-denominated bonds issued by emerging-markets countries, subject to certain liquidity requirements. At this time, there are 28 countries in the index. Eligible securities must be denominated in U.S. dollars, issued by sovereign entities, have a current face amount of $1 billion or more, and have at least two and a half years remaining until maturity. The index is market-capitalization-weighted, so countries with higher levels of debt outstanding receive correspondingly larger allocations in the fund. However, the index does employ country constraints to ensure diversification and to moderate exposure to the most heavily indebted countries. The index, and hence the fund, are rebalanced monthly. Distributions are paid monthly. This fund, with an annual fee of 0.60%, is slightly more expensive than PCY.