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Have Emerging-Markets Bond Funds Emerged?

Has the time come to view emerging-markets debt differently?

Eric Jacobson, 08/02/2012

Emerging markets are hot. But while emerging-markets equity funds took in the bulk of their new assets during the stretch between late 2008 and early 2011, flows into emerging-markets bond funds have remained strong thus far through 2012. The category took in more than $10.6 billion through June, putting it well ahead of the already torrid pace of flows it experienced in 2010 and 2011. With more than $60 billion in total net assets, the category is now more than 3 times as large as it was in mid-2008.

The trend hasn't been limited to dedicated emerging-markets portfolios, either. Managers of intermediate-term bond funds--which often form the core of investor portfolios--have been more likely to hold some assets in emerging-markets debt than ever before. The trend isn't universal, but the highest-profile examples are notable. The industry's largest fund, the $263 billion PIMCO Total Return PTTRX, held 8% in the sector as of June, for example (a weighting that alone equates to one third of the emerging-markets bond category), while American Funds' $33 billion Bond Fund of America ABNDX recently boasted a 4.7% allocation.

The Bull Case
It's clear that many investors have been favoring the sector as an alternative to domestic options whose yields are being held down by tight Federal Reserve policy, and to some degree slow growth and periodic flights to the quality of U.S. debt. Money managers such as PIMCO also make the case that emerging debt markets are more attractive than traditional developed-markets sovereigns, in particular, thanks to stronger underlying fundamentals. The news is awash with stories about high debt levels among advanced economies, but for emerging-markets enthusiasts the real story is just how much lower--and declining--those countries' debt and deficit levels are. Robert Cessine of Morningstar's index group recently covered the issue in a webinar (along with Morningstar bond strategist Dave Sekera) and noted that governments in many of those nations are displaying greater fiscal responsibility, which is leading to lower debt burdens.

Emerging-markets economies also generally boast healthier levels of growth according to data from the International Monetary Fund, which estimates that they will grow some 5.4%, on average, in 2012 versus an anemic 1.2% for developed economies.

Source: International Monetary Fund, Morningstar Indexes.

The case looks even stronger when you consider the long-term trends. There's much more liquidity today given that the pool of emerging markets debt has grown sharply--Barclays' Global Emerging Markets Bond Index has more than doubled in size over the past 10 years--along with the improving credit picture among many sovereign and corporate emerging-markets issuers. Meanwhile, the mix of issuers is much more diverse today than it was just 10 years ago. At that time, well over half of emerging-markets corporate debt hailed from countries in the Americas according to Morningstar index data, for example, with modest issuance in Asia, Eastern Europe, the Middle East, or Africa. Today, the market's composition is more evenly distributed with roughly a third coming from Asia, a third from the Americas, and a third from Eastern Europe, the Middle East, and Africa.

Eric Jacobson is Morningstar's director of fixed-income research and an editorial director for mutual fund content.

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