Not too long ago, BlackRock Inc was super bullish on the prospect of exchange-traded bond funds.
While it took 17 years for these passive vehicles to reach US$1 trillion in assets under management, doubling that would take a fraction of the time, the investment manager predicted. These funds have become “disruptors” of the once opaque and difficult-to-access global bond market, it said.
Passive funds have indeed become popular. More than 60% of institutional investors used debt ETFs last year, up from 20% in 2017.
Meanwhile, emerging market bond ETFs represent the fastest growing segment, rising at an annualised rate of 38% over the last decade, to US$82bil in assets under management.
As much as BlackRock’s marketing executives may tout “disruption, ” instability is one thing developing markets can do without - especially now that they’re issuing debt left and right. Investors are understandably starting to ask who will pay when things go pear-shaped.
If they bail, the passive funds they’ve gobbled up could well kill emerging-market investing.
Take a look at BlackRock’s US$13bil iShares JP Morgan USD Emerging Markets Bond ETF.
It’s well-liked by investors because it tracks sovereign dollar issues, which takes the problem of currency volatility off the table.
But its exposure doesn’t accurately reflect the gross domestic product of its constituents. China, for instance, has a weighting of just 3.8%, making it the eighth-largest component of the ETF.
Meanwhile, Argentina, Turkey, South Africa, Egypt and Colombia - the new Fragile Five according to Bloomberg Intelligence - together have a 14% weight, data compiled by Bloomberg show. Add the next five in line, and about 35% of your ETF’s holdings are vested with the most vulnerable nations.
BlackRock is simply tracking the widely followed JP Morgan index, which is by no means the only one with a heavy tilt toward troubled countries. The Bloomberg Barclays EM USD Aggregate Sovereign Index, for instance, also has more than a third of its weight behind the Fragile 10.
Since the collapse of Lehman Brothers Holdings Inc, quantitative easing has driven bils of dollars of capital into emerging markets. With rates near zero in the developed world, investors have eagerly taken on extra risk in the pursuit of yield.
As a result, nations with current account and fiscal deficits, such as Indonesia, ended up issuing plenty of dollar bonds.
Meanwhile, healthier ones, like export-oriented China and South Korea, developed their domestic government bond markets instead.
After all, it’s cheaper to raise money in your own currency. Beijing only raises dollar bonds when it feels like showing off its prime rating abroad.
Now, the virus is raising uncomfortable questions. Economies big and small are on lockdown, facing large shortfalls in government revenues and big fiscal spending plans.
How will the most vulnerable ones meet their debt obligations?
In mid-April, the Group of 20 agreed to halt repayments for the poorest countries. That won’t be enough. African economies, for instance, have the largest external funding gap among the low-income group analyzed by Moody’s Investors Service Inc.
That amounts to around $40 bil to US$50bil this year, or about 4% to 5% of their combined GDP. The G-20 debt relief is worth only US$10 bil. If, say, a few African countries lit up the global news headlines by walking a tad too close to default, would ETF investors sell out of their positions altogether? It wouldn’t be irrational.
Thanks to passive funds’ transparency, we know at least one-third of our positions are vested with some of the most fragile emerging economies.
BlackRock created retail products from an asset class once preserved for professionals.
This great democratisation experiment is a double-edged sword.
Sure, it helps struggling nations raise money. But in times of distress, contagion becomes the word. Stock pickers - value investors, in particular - have long argued ETFs distort equity markets. That assessment isn’t far off for fixed income, either. — Bloomberg Opinion
The views expressed here are the writer’s own.
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