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By Christine Benz and Eric Jacobson | 07-30-2012 01:00 PM

Emerging-Markets Bonds Similar to Other Risk Assets

Although developing-markets debt purchases have been escalating of late, investors should be aware of the correlations to other assets as well as currency risks, says Morningstar's Eric Jacobson.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Assets have been flooding into emerging-markets bonds, and many general bond managers have been adding them, too. Here to discuss the fundamental case for investing in emerging-markets bonds, as well as some pitfalls to watch out for, is Eric Jacobson. He is director of fixed-income fund research for Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Glad to do it, Christine.

Benz: Eric, there has been a lot of enthusiasm about emerging-markets bonds. Let's talk about why investors are finding this asset class to be increasingly compelling. What is the fundamental case for emerging-markets bonds?

Jacobson: The fundamental case has to do with the growth of emerging markets or better perhaps to say the maturity of them. By that I mean that a lot of the fundamental issues in emerging debt markets look a lot better over time than they used to, and that includes things like better growth in the emerging economies than we have in the developed economies.

We've all been talking about and hearing about the debt levels in the developed markets, such as our own and Europe and what a big problem it is. And in fact those debt levels are much lower in many of the emerging economies now. [There's been] a lot of hard work on the part of emerging nations in terms of their fiscal policies and what have you and just by comparison they look a lot better in some cases. You've also got the issue that there's a lot more issuance now than there used to be. The markets are more liquid and they're more diverse when you look at the breadth of emerging issuers that are out there.

Benz: Those are a couple of the key attractions, increased liquidity and in some cases, better fiscal pictures than developed economies. But let's talk about the potential risk factors for people delving into emerging-markets bonds and also whether you can safely supplant general bond types, general domestic bond types with emerging-markets bonds?

Jacobson: Well the first part of your question [focuses on] what some of those risks are, and for better or worse, the fundamental case looks terrific, when you pick apart all the data for emerging-markets debt. But the fact of the matter is, there are still risks inherent. One of them just by example is the fact that a lot of the newer issuance in parts of the market that are now getting into emerging-markets bond funds are local-issued debt rather than denominated in U.S. dollars, whether it's either sovereign or corporate. And in many cases there's extra currency risk there. Currency tends to be a pretty big volatility factor for bonds, if the risk is present, and it can overwhelm, or drown out if you will, the underlying attraction of holding just the regular bonds.

You also still have a general level of volatility whether or not you're talking even in the U.S. dollar market, which is still relatively large. Emerging-markets debt has been acting much like any other "risk asset" over the last couple of years. We've talked before about this tendency to have things, go risk-on and risk-off in different months, depending on what's going on in Europe, for example. Emerging-markets bonds tend to trade right along very much with high-yield bonds, and there's a pretty high correlation to equities and so forth. So, the risk factors are still there, things to worry about.

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