Choose Your Own Emerging-Markets Bond Adventure

Welcome to the bandwagon. Assets in open-end and exchange-traded emerging-markets bond funds have more than quadrupled from the start of 2010, ballooning to $95 billion in assets as of February 2013 from nearly $20 billion. That interest has spurred fund companies to launch a wide variety of new strategies; the number of open-end funds has risen to 75 from 28 in just three years.

Most of the older funds in that group focus mainly on hard-currency sovereign or quasi-sovereign bonds, those issued in dollars rather than the currency of their country of origin. Historically, dollar-denominated issuance made up the preponderance of these funds' investment universe, as this was the only viable way for countries with dicey fundamentals to gain access to capital. That dynamic has shifted over the past several years, after many maturing emerging markets have cleaned up their finances and have continued to exercise prudent fiscal and monetary policy. That has led to the development of robust domestic bond markets in many countries. In fact, local-currency markets' share of the entire emerging-markets fixed-income universe now tops 80%. Meanwhile, in the dollar-denominated market, emerging-markets corporate bonds have taken up an ever-greater share of new issuance, between 60% and 80% in each year since the global financial crisis.

Many of the category's recent fund launches have sought to capitalize on one of these trends. Nearly half of the funds introduced in the past three years have either a specific emerging-markets local-currency or corporate focus, leaving the emerging-markets bond category divided among hard-currency, local-currency, and corporate offerings. With the exception of a few specific region-focused funds, the same is true for the 16 emerging-markets bond exchange-traded funds available. That complicates the choice for investors who want to have emerging-markets bonds in their overall asset allocation but don't have a strong view on which part of the market to play. Also, the relatively short life of most local-currency and corporate emerging-markets bond funds doesn't give investors much history by which to judge managers' skill. That may partly explain why the category's oldest local-currency bond fund,  PIMCO Emerging Local Bond (PELBX), is also its largest at $15 billion in assets.

The category's older hard-currency-focused funds have also attracted plenty of new money in recent years--the $7.1 billion  Fidelity New Markets Income (FNMIX) and $7.5 billion  MFS Emerging Markets Debt (MEDAX) have continued to receive some of the highest levels of inflows over the trailing 12 months--but the shifting investment landscape has posed challenges for the old guard. Some have added small stakes in corporates and local-currency debt in recent years, but they don't have the flexibility to make sizable shifts among these sectors as valuations may warrant. Some of these teams also haven't invested in the research resources to the same extent as certain competitors that a higher allocation to corporate and local-currency bonds demands. Among this cohort, we retain a high degree of conviction in the Fidelity fund, as manager John Carlson has continued to run it in the same style he has employed throughout its history. But we recently lowered our Morningstar Analyst Rating on the MFS fund to Neutral, as its rapid asset growth has been accompanied by a greater shift toward corporates, and it's less clear how well its managers, albeit experienced, can navigate a wider opportunity set.

Less-constrained total-return approaches that allow investment managers greater flexibility to invest across emerging-markets bond sectors may offer the best solution for fund investors who don't want to micromanage their sector allocation decisions. So far, such strategies are in short supply, but that could be changing. PIMCO is attempting to fill that void with its recent launch of PIMCO Emerging Markets Full Spectrum Bond (PFSIX). Storied emerging-markets specialty manager Ashmore also launched a total-return fund alongside hard-currency, local-currency, and corporate-focused offerings when it entered the U.S. retail fund market close to two years ago. The firm manages more than $70 billion across emerging-markets strategies but has attracted less than $1 billion across these funds. Of all the funds in its lineup, though, the total return fund has attracted the lion's share of assets and now stands at a little more than half a billion.

One total-return strategy that's gotten a lot of attention lately is  TCW Emerging Markets Income (TGEIX), which has rapidly become the category's third-largest fund at $7.6 billion. Our estimation of the fund has improved, as the team has added research and trading resources and expressed its intention to close the fund before it hits $10 billion in an effort to keep its size manageable. But its red-hot returns in recent years are a testament to its risks, and investors should tread carefully.

A version of this article appeared in the April 2013 edition of Morningstar FundInvestor.