The New Allure of Emerging-Market Debt

With growth prospects in the U.S. and other industrialized nations projected to be stagnant over the next few years, where can investors turn for higher yields? The answer for many is emerging-market debt funds and exchange-traded funds, where returns have been far more attractive than, say U.S. Treasury yields, with the added benefits of portfolio diversification and currency appreciation.

Emerging-market debt funds and ETFs invest in the fixed-income securities of developing nations. These securities can include sovereign debt/government bonds; bonds of emerging-market corporations and government-run entities; or other foreign-currency-denominated debt instruments that are typically tied to a country's GDP growth rate or the appreciation of its currency against the U.S. dollar. Already, more than $40 billion has poured into emerging-market debt funds this year.

Three Key Factors

Investors are flocking to these debt funds because several analysts and the International Monetary Fund have forecast that growth rates in emerging markets will more than double those of industrialized nations in 2011. The IMF projects emerging-market economies will grow 6.5% in 2011, compared to 2.6% for the U.S. and 2.4% for other developed nations. But growth is only part of the allure.

"The story for emerging markets for U.S. investors comes down to three things: yields, credit ratings and the U.S. dollar," says Ed Lopez, marketing director of Van Eck Global, which offers an emerging-market ETF.

Lopez says emerging-market debt has more attractive yields that are close to 6% versus 2.5% for 10-year U.S. Treasurys. He also points out that emerging nations have lowered their risk profile because their credit ratings have been getting upgrades, while developed nations have seen downgrades. And the record price of gold indicates that people are moving to precious metals as a hedge against U.S. dollar weakness. All these things favor emerging-market debt as an investment over the debt of developed nations.

"A Comprehensive View"

Cristina Panait, vice president and emerging-market strategist of the $400 million Payden Emerging Market Bond Fund (PYEMX), incorporates all types of debt instruments in her portfolio. Although it primarily comprises sovereign debt, 15% is in bonds of privately owned corporations and 14% in bonds of 100% government-owned companies.

"In order for us to be involved in a country, we have to be positive about its fundamentals. We wouldn't invest in a country just because it has a high yield or everyone is interested in it," says Panait. "We take the approach of having a comprehensive view on all the investment opportunities and pick the ones that we think are most attractive in each country."

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The fund was up 28.9% in 2009 and is up 14.86% through October.

Other emerging-market bond funds to consider include T. Rowe Price Emerging Markets Bond (PREMX), up 13.75% through October; and PIMCO Emerging Local Bond (PELBX), up 16.66% through October.

Emerging-market bond ETFs include Van Eck's Market Vector Emerging Markets Local Currency Bond ETF (EMLC), which doesn't rely on just U.S. dollar-denominated debt but also factors local currency appreciation into its returns. PowerShares Emerging Markets Sovereign Debt Fund (PCY) and the iShares JPMorgan USD Emerging Markets Bond Fund (EMB) are ETFs that track only U.S. dollar-denominated debt.

Beware of a Global Slowdown

Popularity and relatively strong returns, of course, don't eliminate risk. Lopez warns that Van Eck's ETF entails currency risk, so returns could be hurt if emerging-market currencies fail to appreciate against the dollar. Other risks that go along with investing in emerging markets, such as transparency risk and political risk, should always be considered.

"But the main risk is that if you have a double-dip recession in the U.S., it could translate into a general global slowdown," says Panait. If growth drops in many emerging nations, it could worsen their debt situation. It could also bring risk aversion back into the market. And "if investors don't want to own any risk, there could be a flight to quality such as Treasurys," says Panait, "and that might negatively affect emerging markets."

So, be thorough before you invest in emerging-market debt -- and if you do invest, stay alert afterward.