Emerging market bonds: 4 things you need to know

BOSTON — Investors continue to pour their money into bonds. And the decline in the stock market this month certainly won't stem their flight to safer investments.

Yet those willing to accept a bit more risk in the bond market are finding that they are being appropriately rewarded. Emerging market bond mutual funds are among the top performers so far this year. And over the last 10 years, they have posted an average annualized return of nearly 12 percent. That's more than double the return of the Standard & Poor's 500 index, as well as a broad index of the U.S. bond market.

These funds buy bonds issued by governments and companies in a group of about 20 fast-growing nations including Brazil, Russia, India and China. Investors can choose from a dozen mutual funds whose 10-year returns eclipse that of the JPMorgan Emerging Market bond index.

Overall, government finances in the emerging markets are in better shape than in developed nations, including the U.S. Growth has recently slowed in countries such as China and India, but it's important to keep perspective. Their economies continue to expand at a much faster clip than the U.S. What's more, demographic trends in emerging market nations generally are more favorable than in the U.S., with its aging population.

Renowned bond investor Michael Hasenstab has far more of his fund's portfolio in emerging nations, such as Indonesia and Mexico, than in larger bond markets in the U.S., Japan, Germany and France. Hasenstab's fund, Templeton Global Bond (TPINX), can invest across the globe, but he's largely avoiding developed nations.

“The tables have completely turned. The countries that were the biggest credit risks now have some of the best credit,” Hasenstab says. In the U.S. and many other developed countries, “no one has very strong growth ... and fiscal policy is a mess.”

The brighter outlook in developing nations is a key reason why emerging markets bond funds have posted an average return of nearly 8 percent this year. While U.S. Treasury yields are near all-time lows, emerging market bond fund yields have held steady at around 6 percent since 2009. That's about four times the current yield of a 10-year U.S. Treasury bond.

Emerging market bonds have also attracted plenty of new cash. Investors deposited a net $11.6 billion into emerging market bond funds and exchange-traded funds through May.

The recent strong performance doesn't necessarily mean that emerging market bonds will be a good addition to any portfolio. Here are four key considerations:

1. Keep performance expectations in check

T. Rowe Price Emerging Markets Bond (PREMX) has generated an average annualized return of 12 percent ever since Mike Conelius began as manager in 1994. But he acknowledges that several factors came together over the past dozen years, creating what he calls “a nice perfect storm.” Those include rapid economic growth in emerging markets, a global bond market rally and rising commodity prices that have benefited many foreign producers of oil and minerals.

One key risk that Conelius sees for bond investors in general is the prospect that currently ultralow interest rates will rise. When interest rates rise, bond prices decline because investors can purchase newly issued bonds paying higher interest than those issued previously. That could lead to smaller investment returns or even losses for diversified bond fund shareholders, and for investors in individual bonds who don't hold them until they mature.

2. Expect volatility

Emerging market bonds are more likely to deliver sharp ups and downs than most domestic bonds. Reasons include the political and economic instability common in many developing nations. An additional layer of risk comes from currency exchange rates. A rapid shift in rates can have a big impact on short-term investment performance.

That's a key reason why emerging markets funds were the top-performing bond fund category in the first quarter, averaging a 6.9 percent return. But emerging market funds finished the second quarter with a 0.07 percent loss as the dollar strengthened against most currencies as Europe struggled to contain its debt crisis.

3. Know your currency risk

When governments in emerging markets began issuing debt in the 1990s, the bonds were primarily issued in U.S. dollars to attract foreign investors. But as the marketplace matured, some governments began issuing bonds in their own currencies. That can create risks and opportunities for U.S. investors.

A savvy fund manager can navigate the currency markets to maximize returns, but not all the time. To see how much currency risk a manager is taking on, check fund disclosures to learn how much of the portfolio is in dollar-denominated bonds versus local currency bonds. The higher the percentage in local currency, the greater the risk.

4. Understand what you're investing in

Most emerging markets bond funds invest primarily in so-called sovereign bonds issued by governments. But a growing number invest primarily in corporate debt, or in both types of bonds. What's more, many funds don't limit themselves to the 20 or so countries generally defined as emerging markets. Some also invest in frontier markets, such as Bangladesh and Latvia. These less-developed countries offer the prospect of higher returns, but with greater risks. Check fund disclosures to see what proportion of a portfolio is invested in such countries, and assess whether it seems appropriate for your risk tolerance.