Holly Cook, editor of Morningstar.co.uk, talks to Morningstar ETF analyst Jose Garcia Zarate about the fixed income enironment and two current hot topics--corporate bonds and emerging markets. Combining these two areas presents an interesting proposal for income-seeking investors, Garcia Zarate says, provided prospective investors don't become obsessed with investing in hot topics and instead regard this as just one area of a broadly diversified portfolio. This video also discusses a new low-cost tool available to investors for gaining exposure to emerging markets corporate bond--the first ETF to track such an index, the iShares Emerging Markets Corporate Bond fund, an ETF valued in USD that trades on the LSE in GBP.
Holly Cook: For Morningstar, I'm Holly Cook. I'm joined today by Jose Garcia Zarate. He is an ETF analyst with Morningstar. Thanks very much for joining me, Jose.
Jose Garcia Zarate: My pleasure.
Cook: So why don't you set the scene for us, we're going to talk about a bit of a hot topic. What is it about corporate bonds that's got investors so excited?
Zarate: Well, I think in order to understand what's going on with the corporate bond market, you have to actually look at what's going on in the sovereign debt market and particularly developed markets. It is actually a very tricky time for investors. On the one hand, you've got a collection of countries that are at the full risk of default, on the other hand you've got a collection of countries that have become safe havens and therefore the yield on the sovereign bond markets for those countries is actually very, very low. If you put that in comparison with what's going on in the corporate bond market over the past few years, corporations have been very actually good at cleaning up their balance sheet. So what you've got is a market that looks less risky than the troubled sovereigns, but at the same time it's also in the higher yield than the safe haven sovereigns, so kind of like killing two birds with one stone.
Cook: So, as investors are trying to find that income that's so difficult to find at the moment, how can an ETF help them produce this extra yield in their portfolio?
Zarate: I mean the good thing about ETFs is that obviously, we have to understand that they are sort of like index trackers, a trait on the exchange like common stock and that basically makes them very, very versatile and very flexible instruments to implement changes in asset allocation. The other thing that you need to take into consideration is that the cost of actually using an ETF is actually much cheaper than using a mutual fund. So, there is the flexibility and the lower cost, and by virtue of those two things, actually gaining exposure to a market such as the corporate bond market is financially an interesting proposition.
Cook: So for an investor who does want exposure to the corporate bond market, what's on the menu? What's available to them?
Zarate: Well, the corporate bond market, I mean, the offering on ETFs has been growing over the past couple of years because of investor interest, and at the moment we've got a wide range of ETFs offering exposure to the eurozone, the U.K. and the U.S. corporate bond market. And also--you can do it as a means of gaining exposure to the broad market--but also you can actually gain exposure to segments of the market, like for example ETFs that offer exposure to, let's say, corporate [bond] excluding financial corporations, if you're not really keen on getting exposure to bonds issued by banks.
Cook: So you can splice the market as you wish?
Zarate: Exactly. I think the next step is, once the providers have been very sort of proactive in providing exposure to the developed corporate bond market, the next step was obviously taking this to the emerging markets. So, you're basically sort of like joining two very hot topics here, corporate bonds in emerging markets. And basically the next step was taken a few days ago. Basically iShares launched this new ETF which is the iShares Morningstar Emerging Market Corporate Bond ETF.
Cook: So why Morningstar there? Explain what that means.
Zarate: Basically it means that the ETF is tracking an index that is produced by Morningstar. It is called the Morningstar Emerging Market Corporate Bond Index.
Cook: So if an investor buys this new iShares ETF, what exactly are they buying? What sort of exposure are they getting?
Zarate: Basically you're getting exposure to the performance of the corporate bond market of emerging market economies. The index—I have been having a look at the index composition—and it is made up of bonds issued by financial corporations, industrial corporations and also utility corporations, all based in emerging markets., It’s currently, it’s been registered for sale both in the US but also here in the UK. The bonds are USD denominated, but obviously for the purposes of UK investors, the ETF will be trading in sterling on the London Stock Exchange.
Cook: So if an investor is looking for emerging markets debt exposure and an ETF such as this allows them to do that at relatively low cost, is there anything that they need to be aware of about investing in emerging market debt?
Zarate: I think like with everything, there are always risks. I mean, the macroeconomic and the political landscape of emerging markets has changed very substantially--for the better--over the past two decades. But I would think that there is still some element of country risk attached to investing in emerging markets and that has to be taken into consideration. If you're a U.K. investor, obviously as I mentioned before the ETF is going to be trading in sterling but it is USD denominated, so there is a foreign exchange consideration that you need to account for.
So I guess the whole point about investing, not just in emerging markets, is that you need to take a kind of measured approach and you need to try to build a well balanced portfolio. So instead of getting obsessed about the hot topics of corporate bonds and emerging markets, maybe you should approach it in a way that, okay, this is an interesting thing to have, but it's just one of the many asset classes that you should have in an investment portfolio.
Cook: So just one egg in a broad basket.
Zarate: One egg that is actually very tasty at the moment, let's say.
Cook: And how about for the ETFs themselves? Are there particular kind of pros or cons to this structure that again investors need to be aware of before they actually part with their cash?
Zarate: The thing with ETFs, I mean ETFs are classed as kind of like passive investments, because obviously there are index trackers and there are all sorts of economies of scales. What I like to say to investors, just because you're investing in a passive vehicle it doesn't mean that you have to be a passive investor. You still need to do your due diligence and make sure that the ETF that you're buying actually meets your requirements.
For any ETF, but I would think most specifically for fixed income, a crucial consideration is always to understand the index. The index is going to… the performance of the ETF is going to be ultimately the performance of the index that the ETF is tracking. In the case of fixed income, there is not a standard way of measuring a fixed income market. So before putting money into a fixed income ETF, you have to make sure that you understand the index, that you understand the mechanics, that you're happy with the exposure that the index is providing and then you can go into sort of like exploring any other issues such as replication, trading costs and so on, but the starting point: make sure that you understand the index.
Cook: So for an investor who is excited by the potential returns that emerging market debt can give them as opposed to developed market corporate bond or even sovereign bond, this is quite an exciting development and a way that, as long as they fully understand the risks, it's a way that they can tap into that.
Zarate: Absolutely. I mean, as I said to you before, the macro story and the political story of emerging markets has changed for the better over the past two decades. The performance of emerging market instruments, not just sort of like sovereign bonds or the corporate bonds, also equities. I mean, when you compare it to what's going on in developed markets at the moment, I mean, the emerging markets actually look a pretty neat proposition. So, at the moment, yes, as long as you understand the investment risks and that you take perhaps a medium- to long-term view about investing in these countries then it's a good thing.
Cook: Well, Jose, thanks very much for joining us. It's very interesting to get your views on this new way of investing.
Zarate: Thank you very much.
Cook: For Morningstar, I'm Holly Cook. Thanks for watching.
Disclosure: Morningstar, Inc., receives fees for licensing its indexes to ETF/ETN providers. These fees are mainly based on fund assets under management. BlackRock Asset Management; First Asset; First Trust; Invesco; Merrill Lynch; Northern Trust; Van Eck; and Scottrade currently license Morningstar Indexes. These ETFs and ETNs are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on the Morningstar Indexes.
