Emerging markets debt is the new black, thanks to high yields and sound economic fundamentals of many emerging markets countries. The average one-year return for the category is 17 percent as of Sept. 30, according to Morningstar.
The emerging markets, or EM, bond category offers an average 12-month yield of nearly 5 percent, and that has yield-starved investors taking notice.
But it's not all happy harvesting of outsized yields. Emerging markets debt comes with added risks.
Risk versus reward
Emerging markets bonds are issued by either a corporation or the government of a developing country. The category of emerging markets debt is literally all over the map, which can be a challenge for mutual fund investors. Singapore is vastly different from Chile, which is different from South Africa. And then there's China.
All four countries, and many others, show up in various mutual funds. Some funds may even pull in countries that haven't quite made it to the emerging markets threshold. These countries in Latin America, Asia, Europe and Africa are known as frontier markets.
Understanding the strategy you're signing up for is the first challenge for investors. There are distinct subgroups within the emerging markets class. There is sovereign debt -- that is, debt issued by a national government and denominated in dollars -- corporate debt issued in dollars and sovereign bonds issued in local currencies.
"They are all investment-grade (indexes) at this point. They have different weighted average ratings, but they range between BBB- and BBB+, so you're getting investment grade in the index," says Blaise Antin, managing director and head of sovereign research at TCW, an investment firm and independent subsidiary of Societe Generale.
Currency adds a wrinkle
Emerging markets bonds issued in local currencies are pretty popular with investors: They accounted for 66 percent of all EM bond trading in the first quarter of the year and 70 percent in the second quarter, according to the Emerging Markets Traders Association. About 81 percent of all EM government liabilities are issued in local currency, according to a 2011 report from TCW, "Emerging markets insight: Investing in emerging markets local currency bonds."
Using local currency benefits the country by avoiding exchange-rate risks, so the number of EM governments issuing bonds in their own currency has been on the rise.
"For example, the governments of Brazil or Turkey are looking to develop its local market so that it can issue increasing share of its debt domestically and therefore not take any currency risk," Antin says.
While most EM government bonds are issued in local currency, most of the corporate bonds issued in 2012 have been in dollars.
"We've had about $200 billion U.S. issued by emerging market issuers in the dollar market this year. Of that, about two-thirds have been issued by corporates. So roughly $130 billion or a little more by corporates in the first half of the year, and $60 (billion) to $70 (billion) by sovereigns," Antin says.
Mutual funds investing in emerging markets bonds can hold sovereign debt as well as corporate debt, or they may specialize in one or the other.
Bonds denominated in local currencies add diversity to a fixed-income portfolio, but they also introduce a new form of risk. Shifts in the exchange rate between two countries can affect the valuation of investments denominated in other currencies.
When the dollar is doing poorly against local currency, the funds get a boost. If the tides shift the other way, investors can find themselves with the short end of the stick.
"The impact of currency debasement or the impact of stronger currencies on emerging markets is extreme. A shift in the currency could annihilate an emerging market quickly. It puts investors under a significant amount of risk," says Jeff Sica, president and chief investment officer of Sica Wealth Management in Morristown, N.J.
For example, "If you have the rand in South Africa appreciating against the dollar, anything denominated out of South Africa would have the potential to appreciate because of appreciation of the rand," he says. That can be a good thing, but if the local currency goes the other way, weakening against a strengthening dollar, investors in the U.S. can lose out.
Mutual fund investors needn't become world currency experts, but it's something to be aware of when picking funds as well as understanding possible sources of volatility.
The exchange rate is the obvious source of volatility for local currency bonds, but dollar denominated EM bonds are not without their own risks.
"Changes in interest rates or policy rates in the U.S. obviously have a very immediate effect on dollar-denominated securities," says Antin. "Dollar securities are going to respond much more to 50 basis point rallies in 10-year U.S. Treasuries than securities denominated in Brazilian real or Turkish lira or South African rand or whatever local market."
Emerging markets debt good for growth and yield
Even if you view the bond portion of a portfolio as a nest of stability and safety, there may be room for emerging markets bonds that don't quite meet those criteria.
"I think emerging markets debt has a place in a portfolio, but it is a small percentage, not 20 (percent) or 30 percent. It will be pretty volatile. However ... when you add a volatile instrument into a portfolio with several other things, usually it decreases the volatility of the portfolio overall," says Donald Cummings, founder and portfolio manager at Blue Haven Capital LLC in Geneva, Ill.
Besides, it's hard to pan emerging markets as being too risky for investors when developed countries are stumbling. Last year, ratings agency Moody's knocked the U.S. credit rating by a notch, and most recently, Italy was downgraded two notches by Moody's.
Economic fundamentals in developed countries are also floundering. Growth in the U.S. has improved since the financial crisis, but has lapsed into sluggish territory in 2012.
Conversely, some developing countries still have plenty of room to grow and are steaming ahead. For instance, China's growth may be weak relative to its history, but relative to growth in the U.S., Europe and Japan, its strength is something to marvel.
Government debt levels in developed countries are nearly 100 percent of gross domestic product. "By contrast, for EM public-sector debt, the needle barely moved over the past five years," says Antin. "It went from 33 percent of GDP to about 35 percent of GDP, so a 2 percent increase versus a 20 percent increase."
While economic fundamentals are decidedly healthier in emerging markets, investors are compensated for the added risks inherent in emerging markets.
And, almost counterintuitively, EM corporate debt generally has higher ratings than EM sovereign debt -- plus better returns.
"The dollar sovereign index is currently 350 basis points over U.S. Treasuries," Antin says. "The corporate index in dollars, which is rated slightly higher than the sovereign index in dollars, was 395 -- so an extra 45 basis points over the sovereign dollar index, and you're getting one rating notch higher."
The average yield in the local currency index is about 500 basis points more than Treasuries.
For today's yield-starved fixed-income buyers, the high returns in emerging markets debt can be tempting. It may make sense for many investors to diversify into emerging markets debt. But before jumping in, investors should understand the risks and know what they're buying.
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