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By Jeremy Glaser and Steven Pikelny | 05-16-2012 01:00 PM

Want Emerging-Markets Income? Look to These CEFs

Debt in developing markets is not as risky as some think, and closed-end funds are good vehicles to take advantage of the higher yields in these regions.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with closed-end fund analyst, Steve Pikelny. We are going to look at emerging-markets debt and why closed-end funds might be the best vehicle for investing in it.

Steve, thanks for joining me today.

Steve Pikelny: Great to be here.

Glaser: So let's talk a little bit about emerging-markets debt to begin with. Why is this an asset class that investors might want to gain some exposure to?

Pikelny: Well, I think that emerging-markets debt usually gets kind of a bad rap because a lot of investors, particularly Americans, have a very Western-centric view on the world and the idea of investing in these countries is kind of a just a foreign concept to them. But surprisingly enough, I think one of the biggest benefits of investing in emerging-markets debt is that a lot of these countries are solvent. They have very low debt/gross domestic product ratios, and they are taking up more and more of the global economic pie.

Although they might not be safest Treasuries, when you compare them with, say, the eurozone, they are pretty attractive. Another thing is that because they are perceived as riskier, emerging-markets debt typically pays a higher yield. So, for investors looking for this extra income, this could be an attractive alternative.

And finally, I think another one of their big benefits is that they can be used as a good diversification tool. Some of these funds invest in local currency debt, which means that they provide some good exposure to different interest rates and different currencies as well as just a source of actual income.

Glaser: Certainly most investors aren't going to be buying individual bonds in this space. So if you're looking at managed products, what advantages do closed-end funds have over, say, an open-end fund?

Pikelny: Well, the big advantage that closed-end funds have is the fact they are closed. They have an IPO, and the manager is working with a set amount of capital for the life of the fund. For a lot of the open-end funds, they have the problem with inflows and outflows. This means that when the global economy is booming and doing really well, they will get a lot of the inflows and they have to go into these markets, which are typically illiquid and they have to expand their portfolios. And then in down markets when they have a lot of outflows, they have to get rid of these bonds, and because the markets are illiquid, this could be problematic.

Closed-end funds don't have to deal with this because the managers can just buy what they're going to buy and they don't have to worry as much about that extra equation of what the shareholders are going to do, because the shares trade on a secondary market.

Glaser: What are some of the risks of investing in these funds?

Pikelny: Obviously, emerging-markets debt isn't completely riskless. These countries still are emerging, which means that they have less-developed infrastructures and their political systems can potentially be more fragile. There are more susceptible to socioeconomic risks. Another big concern I hear is over the reliability of some of the economic data coming out of these countries. While you should still probably take these with a grain of salt, they probably do still provide a least of useful snapshot for these different countries.

Glaser: What are some of your favorite closed-end funds in this space then?

Pikelny: One fund I really like is FAX, which is Aberdeen Asia-Pacific Income, and the reason I like this is it's one of the few fund vehicles that gives investors access to specifically Asian debt markets and Australian debt markets, as well. So, they invest in local currency and in U.S.-denominated bonds. So, if you're looking for exposure specifically to that region, then this could be an attractive fund.

Glaser: Are there any others that you like?

Pikelny: Another fund I like is ESD, which is Western Asset Emerging Market Debt. They invest mostly in U.S. dollar-denominated debt, and they have kind of a broader focus on the global market. They have a smaller exposure to Asia, but they also have exposure to South America and parts of Eastern Europe, the Middle East, and so forth.

And one more fund I like is TEI, which is a Templeton fund and a spin-off of the company's popular emerging-markets open-end fund. And the last two funds are interesting because they're unleveraged, and a lot of investors are kind of afraid of leverage. So for those investors, those two funds might be attractive, and they're still paying distribution rates of upward of 6%. So that's also good.

Glaser: Well, Steve thanks so much for talking with me today.

Steve Pikelny: Thanks for having me.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

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