The 4 Flavors of Emerging-Markets Bond Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. It's Emerging-Markets Week on Morningstar.com. Joining me to discuss the emerging-markets bond category is Michelle Ward. She's a senior fund analyst with Morningstar.

Michelle, thank you so much for being here.

Michelle Ward: Thanks for having me, Christine.

Benz: Michelle, let's talk about why one might invest in an emerging-markets bond fund? What do you see as the big attractions to this category?

Ward: Just stepping back, the emerging-markets bond category, say, five years ago had roughly 30 distinct funds and less than $10 billion. And if you look at it today, it has ballooned to almost 90 funds and $75 billion. So, obviously it has attracted investors' interest.

I think probably investor interest first peaked just looking at performance. Compared with other fixed-income asset classes, it's been pretty compelling over the long term, and as we can discuss later, 2013 has been a little bit of a rough patch. But over longer periods of time, there have definitely been compelling returns.

Benz: Yields are often higher, and bond investors often shop on yield, as well.

Ward: Right. But I think the key attractions really I think lie in the diversification benefits from investing in emerging-market bonds, especially compared with investors who might be primarily invested in U.S.-centric types of asset classes. So, I think the diversification benefits are definitely part of the attraction.

But at the same time, you also have pretty strong fundamentals. Since the financial crisis, there's been a lot of talk about high debt burdens in developed economies, ours included. But if you look at a lot of the emerging markets that make up the universe, you see lower debt burdens, and then you combine that with the potential for higher growth over the long term.

If you combine those two attributes of the emerging-markets economies, then you can see why investors may have been tempted over the past couple of years to tilt their portfolios toward an area of the market where they might be rewarded more handsomely than in the relatively low yields of the domestic fixed-income markets.

Benz: Right. From a portfolio perspective when I'm thinking about how emerging markets might fit within a portfolio, what are your thoughts on that issue? Does everybody need an emerging-markets bond fund?

Ward: I think everybody should at least consider having some exposure to emerging markets in their portfolios, based on what I mentioned before, just the diversification benefits, and also the potential for more a robust return over the long term.

But at the same time, there's a trade-off to that higher return potential, and in order to invest in the asset class, an investor really has to be comfortable with the potential for additional volatility. So it's something to consider when looking at adding emerging markets to your portfolio.

It's also worth noting that a lot of investors might already have some exposure to emerging-markets bonds, whether through an intermediate-term bond--for example, PIMCO Total Return has been investing in emerging markets for years--or even within investors' target-date funds. We've seen an uptick in target-date series, including some exposure to emerging-markets bonds, during the past couple of years.

You have to take that into consideration, too, if you're looking to add a dedicated emerging-markets bond fund, whether you might already have that type of exposure in your portfolio, and then also consider what kind of volatility you're comfortable assuming to make sure that that allocation--if you do consider it--is sized appropriately.

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Benz: You referenced, Michelle, the volatility that can come along with this category. We've seen it on display certainly in the summer months, where we saw interest rates tick up a little bit, and emerging-markets bond funds responded very, very poorly. Generally, I think a lot of investors probably said, "Wait a second, this is something I was looking to for diversification. U.S. rates jumped up, and my emerging-markets bond fund performed terribly." What's going on, on the performance front with this category?

Ward: Right. 2013 has been a tough year for emerging-markets bonds, in general. The category is down a little over 7% year to date, which is not what anyone really wants to see in their fixed-income allocation.

But there have been a couple of things that have really contributed to the poor performance this year. One is a strengthening U.S. dollar, which can be a headwind for emerging-markets currencies. It hasn't helped especially the emerging-markets bonds, which are denominated in the local-issuing currency.

Second, there are also some fears over slowing growth in China, and just given China's overall importance in the emerging-markets asset class, that also contributed to weigh down returns a little bit.

But, yes, arguably most importantly was the Fed first bringing up this tapering talk, and just the concerns over the withdrawal of capital that has been so supportive of risk assets, including emerging-markets debt, that volatility that surged with the Fed tapering talk also hit emerging-markets bonds particularly hard.

That's the volatility that we speak of, is that even though the fundamentals [of emerging-markets bonds] are relatively strong in periods of market stress and in periods of market volatility, they don't tend to hold up as well as maybe higher-quality U.S. Treasuries would. There is that concern, but many managers might argue right now that given the sell-off we've seen, if you are looking to build a long-term allocation in emerging-markets debt, then this might be an attractive entry point.

Benz: There are a lot of different flavors or at least several key flavors of emerging-markets bond funds that people should be aware of if they are shopping in this category. You might see funds with dramatically different strategies. Let's discuss some of the key flavors of emerging-markets bond funds?

Ward: The category has really evolved a lot over the past 10 years, and that's been really a function of the asset class evolving, as well. Historically, the emerging-markets debt was primarily issued in dollar-denominated debt. It was dollar-denominated, and you didn't take on the currency risk when you bought those bonds. A lot of the oldest funds in the category then are focused only on dollar-denominated debts. So that's one flavor of the category, and most of the older funds in the category, that's what their focus is.

But as local-currency debt, which is denominated in the currency of the issuing country, as that part of the market has grown, we've also seen a lot more launches of funds that are focused on this local-currency debt. That's another flavor, focusing on emerging-markets debt that's denominated in the issuing currency.

Benz: And would yields typically be higher or what's the attraction for managers taking that extra currency risk?

Ward: Yes, the yields do tend to be a little bit higher, and also that currency is another potential source of return. But at the same time it really does amplify the volatility. But if it's attractive, for that reason it can also be a source of return, and additional diversification is diversifying away from the U.S. dollar. This is another avenue to do that. It's also just growing. The majority of the universe's assets are in the local currencies, so that's also just the way the asset class has moved. But, again, it's additional volatility.

Then the third flavor we've seen, which is a little smaller than the other two that we just discussed is [funds focused on] emerging-markets corporate bonds. That is also been a growing part of the universe. We've started to see a couple of funds come up that are focused exclusively on emerging-markets corporate debt.

Benz: As opposed to the government-bond issue?

Ward: Right. [For example], a technology company in Brazil issues debt, and that debt tends to be dollar-denominated. You have the credit risk, but not necessarily the currency risk.

Benz: The final flavor, one I was unfamiliar with, is what you call the total-return strategy. What does that mean?

Ward: It's a strategy that gives the manager the flexibility to invest across the three asset classes that we just spoke about. So, if they think dollar-denominated debt is particularly attractive, maybe they'll add more to that part of the market, and the same for local currency. So it's a way to get exposure to all the different flavors of emerging-market bonds but leave the asset-allocation decisions up to a manager. That's also a newer flavor that we've seen, but we have seen increased launches with those types of funds, as well.

Benz: You brought with you a few of Morningstar's top-rated fund ideas. I'd like to cycle through a couple of them. We have two Gold-rated funds in this category. They're both PIMCO funds, maybe you can talk about what they are and how they're different?

Ward: The two Gold-rated funds--PIMCO offers four emerging-markets bond funds--two of the ones that we've rated are Emerging Markets Bond and Emerging Markets Local, which by its name would imply that one invests in local-currency debt. And the preceding one, PIMCO Emerging Markets Bond, which is the first one PIMCO launched, invests exclusively in dollar-denominated debt.

Benz: You like the team. It's the same team running both products, correct?

Ward: Right. If you don't want to take on the currency risk, then PIMCO Emerging Markets Bond would probably be a better choice. If you want the currency risk, then PIMCO Emerging Local Bond would be the choice. But we like these funds for a couple of reasons.

One, is the team at PIMCO just have a lot of depth and a lot of expertise in the emerging-markets debt area. They have steadily built the team over the years, and now they have nearly 20 portfolio managers that are spread between Munich, Singapore, and Newport Beach, Calif., which gives them a lot of global, on-the-ground capabilities for their research. Then they can also leverage PIMCO's macroeconomic expertise as well as their 50-member credit analyst team when they're looking at either emerging-markets corporate bonds or quasi-sovereign debt.

The other thing that we like about the PIMCO bonds is that they take a relatively cautious approach to the sector. They favor higher-quality countries that have shown credibility in policymaking. It'd be unlikely to see Michael Gomez, who's the lead manager there, load up on a heavily debted emerging-markets country just for a little extra yield pickup. We've also seen through their return patterns that they've been a little less volatile than their category peers, whether you're comparing them with other dollar-denominated funds or in the local currency, they have been less volatile than other local-currency peers.

Benz: Those funds are going to tend to be most appropriate for people buying them in a 401(k) plan or maybe through a financial advisor. You brought along another fund that you like that's a no-load fund that is exemplifying the total-return approach that you just talked about.

Ward: Right. So another fund that we like that takes a little bit different approach is TCW Emerging Markets Income fund, which has the flexibility to invest across the spectrum. It can invest in corporate bonds, it can invest in local-currency debt, as well as dollar-denominated sovereign debt.

It's definitely for those investors looking for a little bit more aggressive fare because it will load up on higher-yielding, credit-sensitive fare if the managers feel that the valuations warrant. But the team there has a lot of experience, and as the fund has grown, they've added more trading resources and more research capabilities. It's a fund that we like, but again it's definitely suited for investors who are comfortable with the risks of that type of wide-ranging approach.

Benz: Michelle, thank you so much for being here to provide a really helpful overview on a category that until really recently had been seeing really huge inflows.

Ward: Sure. Thanks for having me.

Benz: Thanks for watching, I'm Christine Benz for Morningstar.com.