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Emerging-Markets Bond Funds: From Emerging to Converging

This asset class has many strengths, but don't expect a repeat of the last decade.

Kevin McDevitt, 07/22/2010

Emerging-markets bond funds are attracting more attention these days. Emerging-markets equity funds still enjoy greater popularity than do their bond-fund counterparts, this category's assets have roughly doubled during the past 12 months to $28 billion. That increase is partly due to the group's 19% one-year return, but also because it has dominated for years.

In fact, emerging-market bond funds are the best-performing fixed-income category over the trailing five, 10, and 15 years. Only the Latin America stock and equity energy categories have returned more than this group's annualized 11.4% over the past 15 years.

Seismic structural shifts have accompanied the head-turning performance. The image that prevailed in the 1980s and 1990s of chronically indebted emerging markets no longer applies. Today, emerging economies are not only growing more quickly than developed economies, in many cases they are sounder financially, too. Debt/GDP ratios tend to be far lower than the U.S.'s roughly 93%, the U.K.'s 78%, and Japan's more than 200%. The IMF reckons that the average debt/GDP for the Emerging G-20 countries--including Brazil, Mexico, and Russia--is just 37%.

These structural changes have helped bring emerging-markets bonds into the fixed-income mainstream, providing an additional source of potential diversification for fund investors. Whereas these funds had once been considered quite speculative, they now seem worthy of a small, strategic allocation in many investors' portfolios.

Won't Be Fooled Again
It wasn't always this way. In the 1990s, many developing countries had far higher debt levels, defaults were a constant threat, and they had to issue bonds in dollars (i.e., Brady or Yankee bonds) in order to entice U.S.-based investors. High debt levels eventually triggered the Asian currency crisis in 1997 and the Russian default in 1998. Debt markets were obliterated in the latter year, with emerging-markets bond funds falling 22.7% on average.

These two traumatic events spurred many developing governments to clean up their balance sheets. In particular, governments wanted to reduce their dependence on foreign creditors and vulnerability to capital flight. With newly devalued currencies improving their competitiveness, these economies were able to export their way out of trouble. (Something developed economies may have a difficult time replicating.)

As a result, emerging debt/GDP ratios have declined and credit quality has improved dramatically. Hard-currency benchmark JPMorgan Emerging Market Bond Index Global (EMBI Global) has an average credit rating of BB+, which is just below investment-grade. And nearly 60% of its constituents are investment-grade. In contrast, only about 5% of emerging-market debt was investment-grade in 1993.

This has led to narrowing credit spreads versus U.S. Treasury bonds as well as fantastic returns for emerging-markets bond funds and free-floating currencies. According to PIMCO, more than 70% of developing currencies were pegged to the U.S. dollar in 1996, but by 2007, 85% of emerging currencies floated freely.

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