The Appeal of Emerging Markets Bonds

Assets in emerging markets bond funds have more than quadrupled since the beginning of 2006.

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In the United States, Congress is still debating whether to raise the country's debt ceiling, which now stands at more than $14 trillion. And across the Atlantic, the European Union is mulling over plans to bail out nearly-bankrupt Greece, which now carries the world's worst credit rating. That's a snapshot of the developed world.

For a breath of fresh air, investors might take a look at emerging markets. Over the next few years, emerging markets nations like China are expected to grow at a much higher rate than their developed-world counterparts, and their debt-to-GDP ratios pale in comparison. In addition, policymakers in emerging markets continue to raise interest rates, boosting their currencies. For example, the Brazilian real has appreciated roughly 4 percent so far this year against the struggling U.S. dollar. And the Russian ruble is up 8 percent year-to-date against the dollar.

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"The tables have turned," says Tom Roseen, head of research services at Lipper. Many developing markets nations were less affected by the financial crisis that began in the United States, and they have emerged stronger since then. Investors have taken note: Assets in emerging markets bond funds have more than quadrupled since the beginning of 2006, reaching about $50 billion, according to Lipper.

The rationale is simple: Emerging markets bond funds offer generous yields, and expected growth rates in these countries are high. Plus, there is potential for their currencies to appreciate against the dollar. "There really has been a paradigm shift in how clients are viewing non-dollar asset classes," says Rick Harper, director of currency and fixed income at WisdomTree, an investment firm that specializes in exchange-traded funds. There are a number of ways to invest in emerging markets debt.

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One option is ETFs that invest in local currencies, the largest of which is WisdomTree Emerging Markets Local Debt (symbol ELD). It's an actively-managed ETF that occasionally shifts its holdings based on a country's fiscal discipline. The fund currently holds local sovereign debt in 14 countries throughout the world, and its three largest holdings are Brazilian, Indonesian, and Malaysian government bonds.

The majority of assets in emerging markets debt funds reside in mutual funds (about $45 billion, according to Lipper). The recently launched T. Rowe Price Emerging Markets Bond Fund (PRELX) is heavily invested in debt issued by the governments of Brazil and Mexico, and also holds sovereign debt from other countries, including Russia, Turkey, Malaysia, and Thailand. "[The fund has] a yield that's pretty attractive and assets that have a reasonable credit rating," says co-manager Chris Rothery.

Most managers of emerging markets bond funds don't hedge their foreign currency exposure—meaning they invest directly in the local currencies. However, Luz Padilla, manager of DoubleLine Emerging Markets Fixed Income Fund (DBLEX), says there is plenty of money to be made in emerging markets debt without taking on any local currency risk. She invests primarily in corporate debt denominated in U.S. dollars.

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Increased risk comes with investing in local currencies, Padilla says. "What really stands out is the standard deviation," which measures an investment's volatility, she says. Since the DoubleLine fund's April 2010 inception, it has maintained a standard deviation of 2.79 percent, while the J.P. Morgan Emerging Markets Government Bond Index, which tracks local currency debt, has a standard deviation of 10.49 percent.

As corporations in emerging markets begin to issue more debt and become more stable companies, Padilla says they're becoming better investments that provide attractive yields. Since mid-2003, the default rate for emerging markets corporate bonds has been lower than the default rate for U.S. companies, she says. "You really are taking on companies that are on stronger footing if you were just to look at their balance sheets," Padilla says. The fund's three largest allocations are to Brazilian, Russian, and Mexican bonds.