For Emerging-Markets Bond Exposure, These Funds Are Tops

Note: This article is part of Morningstar's December 2013 Emerging-Markets Week special report.

Mention emerging markets to most investors, and the conversation usually turns to equities. But in recent years emerging-markets bonds have been garnering a lot of attention from U.S. investors frustrated by low rates at home and drawn to higher yields abroad.

In fact, during the past three years, investors have plowed $35.6 billion into emerging-markets bond funds--by comparison the much larger intermediate-term bond category added $51.8 billion during that time (as of Nov. 30). More recently, as U.S. interest rates have started to rise with expectations that the Fed may soon begin winding down its bond-buying stimulus program, U.S. investors have been pulling money out of many bond-fund categories. The intermediate-term bond category has seen about $66 billion in net outflows during the past year, yet emerging-markets bond funds have added nearly $2 billion during that time frame. (This trend may be reversing, however; last month investors pulled $1.3 billion from emerging-markets bond funds.)

Aside from higher yields, another reason U.S. investors look to emerging markets for fixed-income exposure is that many emerging-markets countries have lower debt loads than more developed nations as well as faster-growing economies. These characteristics make for a favorable credit-risk profile compared with slower-growing developed nations carrying heavier debt/gross domestic product loads.

However, this doesn't mean emerging-markets bonds are risk-free. Like other bonds, emerging-markets bonds are subject to credit and interest-rate risk. In fact, when interest rates in the U.S. shot up this summer on speculation that the Fed would soon begin tapering, emerging-markets bonds were hit particularly hard, in part because U.S. bonds would begin paying higher yields but also because they are generally regarded as safer investments than emerging-markets bonds.

Other risk factors include the fact that emerging markets are more prone to political instability, which can affect the bonds' values. An even bigger risk factor, however, is currency risk. If an emerging market's currency loses enough value versus the dollar, U.S. investors could lose money on it even if the bond has appreciated in value in its native country. For this reason many funds invest in emerging-markets bonds that are denominated in U.S. dollars, or they hedge out currency risk.

But others use currency exposure as a potential source for added return. There recently has been an increase in the number of these so-called local-currency funds, though this approach can add volatility. Morningstar senior fund analyst Michelle Ward discusses some of these risk factors and various strategies used by emerging-markets bond funds in this video.

Some diversified bond funds already provide exposure to this segment of the market. But for investors interested in adding a dedicated emerging-markets bond fund as a satellite holding to the fixed-income portion of their portfolios, we've set our  Premium Fund Screener tool to screen for funds in this category that have Morningstar Analyst Ratings of Gold, Silver, or Bronze. We've screened out institutional funds and closed funds to focus on those currently available to individual investors.

Premium Members can  click here to see the full screen, which includes the following names.

 Fidelity New Markets Income (FNMIX)    
 | Analyst Rating: Silver      
John Carlson, Morningstar's 2011 Fixed-Income Fund Manager of the Year, has run this fund since 1995 and typically forgoes substantial foreign-exchange and corporate-credit risk to focus on sovereign-credit risk. According to Fidelity's website, the fund held 54% of its portfolio in sovereign debt as of Oct. 31, the majority of it U.S. dollar-denominated. Agency bonds (25%) and corporates (14%) represented other key areas, with a modest equity stake (5%) included. Latin America (35%) and emerging Europe (26%) were key regions, with about 14% of holdings in developed nations. The fund has been a top performer, with annual returns that beat the category average by well more than 2 points during the trailing three- and five-year periods and by more than 1 point during the trailing 10- and 15-year periods. Annual fees are a low 0.84%.

 PIMCO Emerging Markets Bond (PAEMX)      
| Analyst Rating: Gold      
This fund's managers emphasize countries with strong or improving credit fundamentals, such as Brazil, Mexico, and Russia, which combined represented two thirds of fund assets as of Sept. 30. In recent years, lead manager Michael Gomez has shifted assets toward those countries' quasi-sovereign (partially state-owned) and corporate debt while steering clear of heavily indebted countries vulnerable to poor policy decision-making and sudden shifts in investor sentiment. The fund focuses on dollar-denominated securities in contrast with  PIMCO Emerging Local Bond (PELAX), another fund on our list, which invests in debt denominated in local currencies. Performance has been decent--the fund ranks near the category average for the trailing one-, three-, and five-year time frames and carries a below-average Morningstar Risk rating. This fund may charge a load.

 T. Rowe Price Emerging Markets Bond (PREMX)       
| Analyst Rating: Bronze    
Lead manager Michael Conelius has run this fund since 1994 and uses a broadly diversified portfolio built primarily on dollar-denominated emerging-markets bonds while occasionally venturing into local-currency bonds. He recently upped the fund's stake in emerging-markets corporate bonds to about one fourth of fund assets as of June 30. This diversified approach helps keep volatility in check, though recent returns are unremarkable. Three- and five-year annualized returns are just slightly above the category average, but its 10-year performance lands the fund in the top quartile. Below-average annual fees of 0.94% are a plus here.

Performance data as of Dec. 11