Adding a sovereign debt ETF to your passive income/dividend portfolio

By: ispeculatornew
Date posted: 08.19.2010 (4:28 am) | Write a Comment  (3 Comments)

      Post a Comment

When writing about the single country ETF’s, I had mentioned that I anticipate a lot more ETF’s tracking foreign debt to be released in the upcoming years. This week, WisdomTree launched an ETF that could help gain new exposure to these markets. It is not corporate debt but rather national/sovereign debt but ELD certainly looks like it could fit in nicely in a dividend or a fixed income portfolio

Frankly, I don’t understand why there are not more ETF’s that cover sovereign debt. There is much more sovereign debt outstanding for emerging markets than for the US government and much more opportunities as well.

What is ELD?

ELD is a new ETF that was created by WisdomTree, it invests in sovereign debt that is:

-from emerging economies
-denominated in the local currency
-where foreigners can invest

It invests usually by buying government bonds or possible supra national bonds (IMF for example) or could also do swap trades based on these instruments.

In order to determine which countries should be invested in, WisdomTree uses a variety of criteria’s like the credit rating, inflation. debt ratios, CDS prices (which can be used to determine the default probability). The rebalancings are done quarterly and initially 17 countries are owned by the fund (14 of them are investment grade).  These countries are then ranked into 3 groups that determine how much weight they carry.

While most ETF’s track an index, ELD does not. It will be rebalancing in order to maximize return for limited

Historically, the performance of sovereign debt has been very solid. The return since 2003 has been 12% per year, a return that is very similar to that of US corporate bonds. However, the credit ratings of the sovereign debt is higher than the corporate bonds and they provide better diversification so I don’t see why they would not be included in a diversified portfolio.

Dividend Yield

The current yield in the basket is 6.80%. It is not clear if Wisdom Tree will have the ETF distributions be equal to that yield (as opposed to reinvesting into the fund or other options) but given how Wisdom Tree manages its other ETF’s, we can expect the dividend yield on ELD to be close to 6.80% which is considerable in the current environment and a good way to start building a dividend portfolio or add diversification to the one you currently have.

ELD vs EEM

When discussing asset allocation, I often hear talk about Emerging markets. But investing in emerging market ETF’s in an ETF like EEM or VWO is quite different from investing in sovereign debt through ELD. It’s not that one is superior to the other, they both have their pros and cons but I believe that both in the equity and fixed income portios of a portfolio, emerging markets have their place.

Pros

I have no doubt that a product like ELD will provide much needed diversification in a fixed income portfolio. I probably will not need to give you many numbers to convince you that the correlation between the return of a big financial institution and the government of Poland’s debt is very small. Also, the high yield of 6.80% might move over time but in general it will remain higher simply because many investors severely underweight foreign portions of their portfolios which provides great opportunities for those of us that don’t.

Cons

There is no doubt that a few more factors will influence returns on ELD. The interest rates, inflation rates and exchange rates will all have a significant impact on your return and will bring more volatility. That might cause dividend yields to rise and fall much more often than a domestic fixed income security. It could go in either direction though so you should not necessarily see it as a huge downside.Another con in my opinion is that since the ETF is not tracking an index, it will be more difficult to judge and evaluate the performance

Will I be buying?

I will personally probably be a buyer of this ETF in the near future. I will wait to see how exactly they are redistributing income from the fund but chances are good that you will soon see this ETF in my dividend portfolio. Just a side note, I don’t think that adding ETF’s to a dividend portfolio is that useful in general but in some cases such as this one, it would not be possible to add this type of exposure for an individual investor with this portfolio so I’m more than happy to try it out. How about you?

If you liked this post, you can consider subscribing to our free newsletters here


3 Comments

  1. Comment by John — August 19, 2010 @ 7:46 am

    Can you really call it Dividend yield? I thought that dividend yield was for stocks?

    Based on criteria, the top 5 countries are USA, Malysia, Brazil, Mexico and Thailand. I think it’s pretty risky for sovereign bonds. Don’t you think?

    What’s the difference with ELD and EMLC. Would you recommend ELD more than EMLC?

    Thanks! And keep us with the updated redistributing income!!

  2. Comment by IS — August 19, 2010 @ 4:00 pm

    @John – Good questions, thanks! Technically, yes because it is an ETF that pays out dividends. The dividends do come from bond yield (bonds) but it is converted through the ETF.

    Risky in terms of going bankrupt? No, sovereign bankruptcies are very rare (Russia, Argentina)

    The main difference is that ELD is actively managed, while EMLC tracks an index. That will end up making a big difference in the weightings of each country.

  3. Pingback by DGB Roundup — August 20, 2010 @ 6:19 am

    […] Who would have thought that you can create your own ebook in 5 easy steps? 2. The pros and cons of adding a sovereign debt ETF to your passive income/dividend portfolio is written by Intelligent Speculator. This is helpful for that that have or are interested in […]

RSS feed for comments on this post.

Sorry, the comment form is closed at this time.