Investors warm up to emerging market bonds

July 14, 2011

Talk about a paradigm shift.

In the late 1990s, the Asian currency crisis and Russia’s massive debt default crushed bonds issued in emerging markets in Asia, Europe and Latin America. Just three years ago, emerging market bonds tumbled as investors ran from anything that smelled of risk.

Now, as debt woes envelop the U.S. and Europe, economies in many developing countries continue to chug along at a healthy clip. And investors, drawn by strong returns and high yields on emerging market bond funds, have put a fledgling asset class on the map.

Last year those funds absorbed over $53 billion in new money according to the EPFR Report. This year investors have added another $15 billion, bringing total assets in the group to over $186 billion.

The driver behind this popularity has been performance. During the year ending July 11, emerging market bond funds had a total return of 12.4 percent, compared to 6.1 percent for taxable U.S. intermediate-term bond funds, according to Standard & Poor’s. Over the last three years they’ve averaged annualized returns of 9.3 percent, compared to seven percent for the latter group. The funds’ average 4.6 percent yield also beats the 2.76 percent yield on their U.S. counterparts by a considerable margin.

Behind those numbers is a story of how emerging market issuers have evolved from the bad boys of the bond world to up-and-coming role models with increasing financial strength. In emerging market countries, the average debt-to-GDP ratio — a measure of government debt as a percentage of gross domestic product — is less than half that of the U.S. and other developed countries. Nearly 60 percent of emerging market countries are rated investment-grade (BBB or higher), according to a report from Prudential, up from just 2 percent in 1993.

Companies in emerging markets often carry less debt than similarly-rated U.S. companies, and a number are top global players in their industries. Among them: Chili’s Codelco, the world’s largest copper producer; Russia’s Gazprom, a global leader in natural gas production; and Brazil’s Petrobras, a major offshore oil exploration company. All are rated investment grade, as are nearly 70 percent of emerging market corporate bonds.

Emerging market bonds are a growing presence in several high-yield indexes, which should help prop up demand, and the market is also more liquid than it was a few years ago. By 2014, predicts J.P. Morgan Chase & Co., the size of the emerging market bond market will equal the size of the U.S. high-yield bond market.

Those interested in emerging market bonds can choose from a growing roster of mutual funds that mine this space in different ways. Some skirt currency risk by investing exclusively in U.S. dollar-denominated bonds, while others seek to profit from a weakening dollar through bonds denominated in local currencies. Most of the funds invest in a mix of the two.

Recently, strengthening emerging market currencies have benefited the local currency end of the market. Over the last year, that factor has been a major reason why the 9.6 percent return for PIMCO Emerging Markets Bond, which invests in U.S. dollar-denominated bonds, trails the 14.2 percent return for PIMCO Emerging Local Bond, a local currency denominated-only offering.

But fluctuation against the greenback makes local currency bond funds more volatile than those that invest in dollar-denominated securities, or a mix of the two. Most currency-only funds have been around for less than a year, so they don’t have much of a track record. And a strengthening of emerging market currencies this year is far from a sure thing.

Luz Padilla, who manages the DoubleLine Emerging Markets Fixed Income Fund, is bypassing local currency bonds because inflation and government efforts to control it could slow growth in emerging markets and dampen further appreciation in emerging market currencies. Instead, she is focusing on dollar-denominated corporate bonds because of their attractive yield, lower volatility and potential for appreciation through credit rating upgrades.

“I don’t mind taking on the added volatility of local currency bonds if it means achieving better returns than dollar-denominated securities,” she says. “But I don’t think that’s the case right now.”

Funds in the Lipper Leader’s group for total return and consistency of returns over the last three years take different approaches to currency exposure. Some, such as PIMCO Emerging Local Bond, invest exclusively in the local currency government and corporate bonds. Others, such as Columbia Emerging Markets Bond and TCW Emerging Markets Income, invest in varying mixes of dollar-denominated and local currency bonds. Aside from currency translation, the performance of these funds and others in the group is also affected by a fund manager’s country, company and bond maturity choices.

Even in light of positive developments in emerging market countries, it’s important to keep in mind that these governments and companies have only cleaned up their governmental policies and balance sheets in the last few years. Many of their bonds are rated below investment grade, and in some countries, such as China, corporate transparency and reporting are still murky. To help control risk, many financial advisers and pension funds allocate no more than 10 percent of a fixed-income portfolio to emerging market bond funds. That’s a good guideline for individuals to follow as well.

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[…] Emerging market economies continue to show signs of growth and consistency, while the world’s economic cornerstones remain uncertain and stagnant. Drawn by high yields and strong returns, many investors have sought opportunity for big gains in emerging market bond funds.  In the past two years, emerging market funds have absorbed nearly $70 billion in foreign investor money. Solid fund performance and sturdy economic prospects continue to attractive investors. During the year ending July 11, emerging market bond funds had a total return of about 12.4%, more than double that of comparable U.S. bonds. Conditions are likely to persist, as nearly 60% of emerging market countries are rated investment-grade or higher. Additionally, the average debt-to-GDP ratio for these developing economies is less than half that of the U.S. and other developed economies. Investors interested in emerging market bonds have the option of buying either dollar denominated bonds, or bonds denominated in local currencies.  U.S. dollar denomination does reduce foreign exchange risks, though profit opportunities exist in taking advantage of a weakening dollar and investing in the local currency. Though many locally denominated funds have shown superior growth in the short-term, the prospect of currency fluctuations again the American dollar makes these funds more volatile. […]

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