If one thing sticks out about 2011 for most investors, it is the broad fears that struck the sovereign bond market throughout the year. Both European and American bonds faced issues in the period as worries over downgrades in the U.S. and outright default in Europe dominated the headlines for much of the year. While U.S. government bonds have managed to rally despite this news, many European securities have not been so lucky, pushing yields to levels not seen in the euro zone era.

In light of these issues, many investors have decided to take a closer look at emerging market bonds for more diversified exposure in their bond holdings. For investors seeking access to this area, there are a number of choices including regional ETFs as well as broad funds that target a wide range of countries around the globe. In this global bond ETF space, investors have another choice to make as well; dollar denominated or local currency-based bonds (see ETFs vs. Mutual Funds).

Although the dollar has strengthened in recent weeks thanks to broad European fears, one has to believe, given the poor fiscal fundamentals of the nation, that the dollar could be headed lower in the years ahead. For these investors, a purchase of a locally-denominated bond ETF could be ideal as it could provide capital appreciation, a solid yield, as well as gains from emerging market currency appreciation. If the dollar weakens, this could lead to an extra boost in gains for U.S. investors even if emerging market bond performance is otherwise flat (read Three Outperforming Active ETFs).

Thanks to these potential positives, it could be worthwhile to take a look at any of the following ETFs as an interesting way to diversify bond holdings. While the products may not do that well if European turmoil continues in the near term, they seem poised for strong long-term performance as a result of the robust fundamentals underlying these nations and their fiscal positions. Most countries in these funds have debt-to-GDP that is a fraction of their Western counterparts suggesting that they may be safer than you think for bond exposure. Add in the higher yields that stretch pretty much across the board—none of the funds on this list yields less than 5%-- and an emerging market bond ETF could be an excellent choice for most investors.

iShares Emerging Markets Local Currency Bond Fund (LEMB)

This relatively new fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the Barclays Capital Emerging Markets Broad Local Currency Bond Index. This benchmark seeks to give investors broad exposure to a basket of sovereign bonds from emerging markets that are denominated in a nation’s home currency. The product has 44 securities in total, charges investors 60 basis points in fees and has just under $30 million in assets under management (see India ETFs: Behind The Crash).

The product is heavily exposed to South Korean bonds (20%) which are closely followed by Brazilian bonds which make up about 13.6% of total assets. Other countries rounding out the top five include Mexico, Poland, and Thailand, suggesting that the product has a good level of geographic diversification. In terms of fundamentals, the effective duration of the ETF is just under four years although it should be noted that roughly 10% of the bond fund’s portfolio consists of securities that mature in at least 15 years. Despite the product’s tilt towards short-term securities, LEMB does pay out a decent yield to investors, offering up payouts of close to 5.3% in 30 Day SEC Yield terms.  

Market Vectors Emerging Market Local Currency Bond ETF (EMLC)

This bond ETF looks to replicate the price and yield performance of the J.P. Morgan GBI-EMG Core Index. This benchmark provides investors direct exposure to local currency bonds issued by emerging market governments around the world. EMLC has just over 170 securities in its portfolio, has a gross expense ratio of 49 basis points and has amassed close to half a billion in assets since its launch in the summer of 2010 (read German Bond ETFs In Focus).

Unlike LEMB, this fund imposes a 10% cap on the weighting allocated to a particular nation, ensuring that assets are well spread throughout the countries. Four nations currently make up 10% of total assets—Brazil, Poland, South Africa, and Mexico, while Malaysia and Turkey both have bonds that constitute at least 9% of the fund as well. Thanks to the broad trend towards safer assets, EMLC has underperformed broad bond indexes so far in 2011, losing about 8.8% year-to-date compared to a gain of about 4% for AGG. However, it should be noted that the payout for this product is quite impressive, coming in at 6.4% in 30 Day SEC yield terms.

SPDR Barclays Capital Emerging Market Local Bond ETF (EBND)

This product from State Street also looks to provide exposure to emerging market government bonds giving investment results that correspond to the price and yield performance of the Barclays Capital EM Local Currency Government Diversified Index. This benchmark looks to include government bonds issued by developing nations, in local currencies, that have a remaining maturity of one year or more and are rated B3/B-/B- or higher. In addition, the securities in the index must be fixed-rate and have certain minimum amounts outstanding, depending upon the currency in which the bonds are denominated. Much like EMLC, close to 170 securities are in this fund’s portfolio but the product does charge more in fees—50 basis points—and have less in assets-- $47 million—than its Van Eck counterpart (see Top Three High Yield Real Estate ETFs).

For individual country holdings, this product shares some similarities with both of the aforementioned ETFs. South Korea and Brazil take the top two spots, combining to make up close to 25% of the portfolio, while Mexico, Poland, and Malaysia round out the top five. The product is heavily concentrated in short-term securities with close to 55% of the portfolio maturing within five years, pushing the duration down to 4.6 years.  Since launching earlier this year, the product has lost about 2.2% but pays out close to 5.6% in 30 Day SEC yield terms. Both of these figures, along with its expense ratio and AUM, put it in the middle of the back for local currency emerging market bond ETFs.

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