NEW YORK -- For all the worries about how the Federal Reserve's cutback in bond purchases would hurt the market, the biggest pain is being felt far away. It's in Indonesia, India and other developing economies.
Investors are pulling money out of emerging markets, in part because of anticipation of higher interest rates in the U.S. The drop in demand means prices for bonds from emerging markets have tumbled over the last year, and the average emerging-market bond mutual fund has lost 6.8 percent. That's the worst performance among the 32 bond fund categories that Morningstar tracks and a sharp reversal. Over the last five years, emerging markets have provided some of the best bond returns.
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It's no surprise that the Federal Reserve's move is affecting bond markets around the world. But prices have dropped so much for emerging-market bonds -- and the selling has been so widespread -- that managers of bond funds say portions of the market are looking more attractive. To be sure, the managers aren't saying that emerging-market bonds are a slam dunk, many risks still remain, but managers are paying more attention.
"This is where we should be, and are, spending our time looking for opportunities," says Lon Erickson, portfolio manager at Thornburg Investment Management.
Consider that an emerging-market bond offers about 2 percentage points more in yield than a U.S. bond with a similar credit rating, says Wes Sparks, head of U.S. taxable fixed income at Schroders.
"At some point, investors get over the fear about emerging markets," Sparks says, "and they'll start to differentiate between the good countries and the bad countries."
Big swings have been typical in the history of emerging markets. Just go back to Asia's financial crisis in 1997 when currencies for several countries plummeted, or to Russia's default on its debt in 1998. Worries about everything from political protests to heavy-handed regulation can also hurt the market.
More recently, investors tired of the low interest rates offered by U.S. bonds flooded into emerging markets in search of higher yields. In 2012, assets in emerging-market bond mutual funds grew by 67 percent as they took in $21.6 billion of net investment, according to Morningstar. Such funds returned an average of 18 percent in 2012. That was more than double the 7 percent return for U.S. intermediate-term bond funds, the largest bond-fund category.
Besides locking in higher yields, investors were also hoping to further diversify their investments. They were buying bonds from countries where economic growth was stronger than in the developed world -- and expected to stay that way.
Performance last year, though, went the opposite direction. Fears flared after speculation rose in the spring that the Federal Reserve would trim its monthly program to buy $85 billion in bonds. Emerging-market currencies weakened, and a slowdown of economic growth in China and other developing nations worried investors.
Emerging-market bond funds lost an average of 7.3 percent last year, and investors pulled money from the category every month in the second half of 2013.
The selling has continued this year, after tensions in Ukraine and Russia exacerbated worries about emerging markets. Investors pulled about $1.2 billion in each of January and February, according to Morningstar's most recent data. That's close to the average amount that they pulled monthly from June through December 2013.
Even with the increased anxiety, default rates improved last year. The default rate for junk-rated corporate debt in emerging markets was 2 percent in 2013, down from 2.6 percent a year earlier, according to Standard & Poor's. That's lower than the 2.1 percent default rate for the U.S. last year and the 3.3 percent rate for Europe.
Performance has also recovered somewhat. As a group, emerging-market bond mutual funds are close to break even for the year to date. Over the last month, they have returned an average of 0.8 percent.
Investors often lump all emerging-market bonds together and treat them the same. But they're a diverse group, with some bonds denominated in U.S. dollars and others in local currencies. The bonds are also issued by both emerging-market governments and companies.
Don't be surprised if emerging-market bonds denominated in dollars are among the top performers in the bond market for 2014, and bonds denominated in emerging-market currencies are among the worst, says Sergio Trigo Paz, head of emerging-markets fixed income at BlackRock.
Dollar-denominated emerging-market bonds will benefit from a rise in the U.S. currency, which he says is likely with the Federal Reserve moving closer to raising interest rates from their record low.