Thesis

The VanEck Emerging Markets High Yield Bond ETF (NYSEARCA:HYEM) is a fixed income exchange traded fund. We have covered this name before throughout time, with our last rating roughly a year ago, when we assigned it a 'Hold' after a prior 'Buy' rating:

The ETF has rallied since, in tandem with U.S. junk bonds, which have seen spreads tighten.

In this article, we are going to revisit HYEM and the hard currency EM bond space and articulate why EM is currently exhibiting signs of frothiness, with the market warranting caution.

A great start to the year for EM bonds

First, let us remind readers that HYEM focuses on U.S. dollar-denominated bonds issued by non-sovereign emerging markets issuers that are rated below investment grade. The fund thus does not take any currency risk, and generally aggregates EM corporate exposure. The companies that are able to issue in USD, however, are usually large, well-known EM corporates.

EM fixed income has had a phenomenal start to the year, with issuance surpassing the 2023 volumes:

The narrowing of credit spreads globally has helped companies across the credit spectrum raise debt at attractive levels.

This is usually how debt capital markets work - when spreads are tight and the appetite is high, companies try to issue for the entire year. Bloomberg has a very interesting piece regarding the EM issuance so far this year, which you can read here. Their punch-line is that the rest of the year is set for lower issuance and wider spreads.

Per Bloomberg, the market seems saturated in terms of issuance, with companies aggressively taking advantage of the low spread environment, and the next move is expected to be in a slight widening in spreads.

This translates into HYEM having seen the bulk of its gains for 2024 already.

Spreads are at decade long low levels

Just like the U.S. junk bond market, an investor can look at USD EM credit spreads to get a sense how they tally up historically:

The ICE BofA Emerging markets Corporate OAS is at a level not seen since 2018, namely at 187 bps. We can see the tremendous narrowing which has occurred in the past six months, with spreads coming down from close to 300 bps.

Just like their U.S. counterparts, EM spreads are to be bought when they are wide and held or sold when they are very narrow. All-in yields are high given the level in risk-free rates, which dampens the sentiment to cut exposure here. Nonetheless, today's environment is frothy, and caution is warranted.

Fund composition - overweight China

The ETF contains exposure to a wide number of jurisdictions, with China being the top one:

China is followed by the UK, Turkey and Brazil. Financials represent the largest sectoral allocation here, standing at 28%:

We like the sectoral allocation here, with Chinese financials already going through balance sheet restructurings on the back of a prolonged recessionary period in the local real estate market. Financials look attractive after the bad news and loan loss provisions are baked in. Energy is another sector to be bullish on globally, on the back of a commodity boom cycle.

Performance - a great portfolio diversifier

HYEM has a very high correlation with U.S. junk bonds, but with a higher beta factor:

In times of low interest rates or low credit spreads, HYEM offers a greater total return when compared to the SPDR Bloomberg High Yield Bond ETF (JNK), but in times of market stress the fund drops more in value. We can clearly see that beta factor in the 2022/2023 period, when HYEM recorded a much deeper drawdown when compared to JNK. Expect this correlation to continue, with the next market risk-off event seeing HYEM experience a larger drawdown than its U.S. focused peer.

The ETF represents a great portfolio diversifier when looking for high yield. Adding EM exposure to a portfolio of US only junk bonds is a portfolio diversifier and can add alpha during a market bull run. Let us just take an example - HYEM has a high allocation to China financials. While the U.S. has experienced some CRE stress, it is nothing compared to the China CRE price collapse:

The Chinese CRE market has been under duress since 2020, with a number of notable defaults:

Evergrande’s default on repayments to international investors in 2021, after Beijing began cracking down on excessive borrowing for real estate, sent shockwaves through China’s property sector, which accounts for an estimated 15-30 percent of the economy.

More than 50 Chinese real-estate developers have defaulted or missed payments during the past three years, according to credit ratings agency Standard and Poor’s (S&P).

This has translated into banks taking loan loss provisions and already embedding defaults in their Tier 1 capital and solvency ratios. The U.S. conversely is only starting to recognize significant losses on the balance sheet and buildings come for refinancing and there are no bidders. Financials in China are therefore better positioned from a capital perspective, and thus constitute a portfolio diversifier.

Conclusion

HYEM is a fixed income exchange traded fund. The vehicle focuses on hard currency EM debt and has a high correlation to JNK's performance. The fund is a portfolio diversifier via its EM corporate build and exhibits a high beta in a bull market.

The fixed income EM space has seen a plethora of issuance so far in 2024, with credit spreads close to decade long lows. The pace and volume of issuance attest to frothy markets, with the only natural next step being for spreads to slightly widen from here. HYEM has been a great portfolio diversifier historically and will continue to be one, but retail investors are cautioned here with markets stretched. The ETF is only a hold at current levels given its diversifying capabilities, while more conservative investors can choose to even cut some exposure here, in tandem with cutting overall high yield allocations.