In a video blog a few months ago, I recounted – much to the amusement of my co-workers — the trouble I ran into trying to buy a municipal bond for my personal account.
Being a former trader, I thought this should be a pretty easy task. I did my research, picked a bond and told my broker which one I wanted to buy. But I was in for a surprise.
Not only did my broker not know how to access the bond I wanted, but when he did figure it out, the price he offered me was 5 points beyond what I thought was fair. Given how illiquid the bond was, my broker wasn’t willing to budge on the price. Needless to say, I did not buy that bond.
I was reminded of that experience when iShares launched LEMB last month. It’s the iShares Emerging Markets Local Currency Bond Fund, and it gives investors exposure to bonds denominated in an issuers’ own domestic currency – like the South Korean won or the Brazilian real.
Buying a local currency emerging market (EM) bond is a very difficult task for most individuals. It makes buying a muni bond almost simple by comparison. Here are some of the hurdles one could expect to face:
1. Currency trading. In most developed markets you can purchase a local currency bond and then do a currency trade based on how much local currency you need to settle the transaction. The bond and the currency trade both settle on the same day. In some local markets, such as South Korea, you must first buy the currency and have it settle before the bond trade. An investor who isn’t aware of this convention could inadvertently fail on the settlement of the bond and incur a failure charge.
2. Establishing local brokerage or custodian accounts. Rather than establishing a single account to buy bonds, each investor (and fund) must establish their own accounts and set up relationships with local traders in each market. That’s a lot of long distance phone calls.
3. Clean vs. Dirty Prices. Most fixed income instruments are quoted using so-called clean prices, which do not include any accrued interest on the securities. In some markets, such as Israel and Turkey, bonds are quoted using dirty prices, which include accrued interest. An investor needs to know how a bond is quoted and traded to make sure they are executing at the right price.
4. Taxes. Investors must untangle the complications of the local market tax regimes. One good example is Brazil where a 6% IOF (Imposto sobre Operações Financeiras) tax is collected immediately when a bond is purchased. This is in addition to capital gains taxes that are assessed based on the buyer’s holding period. In other markets, income taxes are also collected. Some of these taxes are rebated back to the investor (or the fund) after the tax returns are prepared based on tax treaty rates between the countries. Expert tax advice is needed to ensure all taxes are properly paid in each jurisdiction, especially since the rules can change each year.
Bonds do not trade like stocks, and investing in individual bonds – especially local currency emerging market bonds — can be time consuming, complex and expensive. But at the same time, EM debt can be used by an investor to complement existing emerging market equity exposure, diversify away from US dollar exposure or broaden your fixed income portfolio.
This is what makes local emerging market debt such a good fit for an ETF. An investor can trade directly on the stock exchange and get access to local bonds without all the hassle of buying the bonds directly. For investors who wish to access local currency emerging market debt, ETFs like LEMB can provide a compelling solution.
When comparing bonds and iShares Funds, it should be remembered that management fees associated with fund investments, like iShares Funds, are not borne by investors in individual bonds.
Bonds and bond funds will decrease in value as interest rates rise.
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Diversification may not protect against market risk.
Narrowly focused investments typically exhibit higher volatility and are subject to greater geographic or asset class risk. Bond funds may be subject to credit risk, which refers to the possibility that the debt issuers will not be able to make principal and interest payments.
The information and examples provided are not intended to be a complete analysis of every material fact respecting tax strategy and are presented for educational and illustrative purposes only.