Combing Through the Emerging-Markets Debt Category

Nearly half of emerging-markets debt funds are less than three years old, bringing the total of open-end and exchange-traded offerings to around 110 today. Given this, investors are faced with a lot of unproven choices. They also have many different approaches to consider as the makeup of the emerging-markets debt universe has changed over the past decade. Today this group contains four approaches that come with varying levels of credit, interest rate, and currency risk.

The Clearest Distinction: Hard vs. Local Currency
Most of the group's oldest funds were launched in the 1990s and focus on emerging-markets debt denominated in U.S. dollars. These are referred to as hard-currency or external-currency funds and currently represent about one fifth of the category. While investors aren't exposed to the currency risks of the underlying issuers, they are taking on credit risk stemming from political, regulatory, or market developments. A commonly used benchmark for such funds is the JPMorgan Emerging Market Bond Index Global, or EMBIG, which contains roughly 60 sovereign credits. That includes many lower-rated countries such as Venezuela, Ukraine, Hungary, and Argentina. Many of the index constituents are export-dependent nations that can be vulnerable in global economic slowdowns.

Hard-currency funds were the only game in town for a while, but the tide started to turn in the mid- to late-2000s as debt issuance in local currencies began to overtake the U.S.-dollar-denominated market. Local-currency funds, which give investors exposure to the currencies of the underlying issuers, now represent nearly one third of the category. Many use the JPMorgan Government Bond Index-Emerging Markets, or GBI EM. It sounds quite similar to the previously mentioned bogy, but it is very different in its makeup. It has only a fourth as many constituents, and all but a few are rated investment-grade. These funds tend to have less credit risk than their hard-currency counterparts.

Another difference between the two groups is that local-currency funds tend to have shorter maturities and shorter durations and are therefore less sensitive to changes in interest rates. That said, these funds have been riskier overall because of their exposure to currency movements. To illustrate, 2013 was a difficult year for most developing-markets currencies relative to the U.S. dollar. Two of the worst performers that year were the Brazilian real and Turkish lira, which slid by 13% and 16% versus the dollar.

Emerging-Markets Corporates or All of the Above
As corporate issuance has picked up in the developing world, so have launches of dedicated emerging-markets corporate funds. These funds started appearing on the scene in 2007 and today make up just about 10% of the emerging-markets debt group. A commonly used index, the JPMorgan Corporate Emerging Markets Bond Index, or CEMBI, contains exposure to issues from a wide variety of countries (roughly 40). Investors here are taking on various credit risks at both the company and country level. But like the hard-currency group, they aren't layering in much currency risk as the debt in these funds tends to be U.S.-dollar-denominated because of legal restrictions and poor custody arrangements in the local markets.

Lastly, around one third of the emerging-markets debt category is composed of free-ranging funds that can invest in hard- or local-currency debt as well as corporates depending on where their managers see the best relative values. Returns of U.S.-dollar-denominated and local-currency bonds can differ widely because of changes in domestic interest rates and currency fluctuations, and technical factors such as shifts in sentiment between domestic and nondomestic investors can also have an impact on performance. Given the newness of many of these funds, investors need to do their homework in order to be comfortable with the investment team and its approach to finding these relative values.

How Have They Fared?
It's hard to make long-term comparisons across all four of these groups given the wave of recent fund launches. Still, it's clear that local-currency options are the most volatile way to invest in this asset class. Over the past five years through July 31, 2014, the typical local-currency fund experienced 1.4 times as much volatility (as measured by standard deviation) as the average hard-currency offering. And in terms of performance, the typical hard-currency fund's 9.5% annualized return for the five-year period was nearly 400 basis points better than the average for the local-currency group thanks to the strengthening U.S. dollar. None of the pure local-currency funds have a 10-year record yet; however, the local-currency-focused GBI EM index's 9.8% annualized gain for that period edged out the hard-currency-focused EMBIG index by 80 basis points per year on average.

The funds' gains in recent years are tantalizing, and these countries generally look attractive compared with much of the developed world in terms of lower debt burdens and higher growth potential. However, emerging-markets-debt funds tend to suffer when big-picture concerns, such as a slowdown in China or U.S. interest-rate hikes, grip the market. That was true in risk-off markets such as the third quarter of 2011 and during the 2013 summer bond market sell-off, when these funds posted significant losses compared with U.S.-oriented core bond funds and even their world-bond counterparts. So, for many investors, emerging-markets debt funds are best used as satellite holdings.