Emerging-Markets Bond Funds: What You Need to Know

Note: This video is part of Morningstar's May 2015 International Investing Week special report.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Emerging-markets bond funds post attractive yields, but what role should they play in investors' portfolios? Joining me to discuss that topic and to share some picks is Karin Anderson--she is a senior analyst with Morningstar. Karin, thank you so much for being here.

Karin Anderson: Thanks for having me, Christine.

Benz: Karin, you recently authored a report where you looked closely at this asset class. You discussed some of the favorite funds within the asset class as well as the role that these funds might play in investors' portfolios. Let's start with a really basic question. What is the case for emerging-markets bonds in investors' portfolios?

Anderson: You hinted at it already. Attractive yields have been one reason to include emerging-markets bond funds in a portfolio. Over the past 10 years, for example, emerging-markets bonds have yielded about twice as much as developed-markets bonds. And another reason that they are useful is for diversification away from U.S. bond markets and the U.S. dollar.

Benz: One thing you see, though, from the standpoint of diversification is that they do tend to move similarly to the equity market, so you want to keep that in mind when you hold them in your portfolio.

Anderson: Exactly. These are very volatile fixed-income funds, and particularly in market sell-off periods where risk assets are falling, these bond funds tend to lose quite a bit of money--similar to U.S. high-yield funds. They act quite a bit like U.S. equities, so investors should really keep that in mind when allocating to one of these funds.

Benz: One thing you note in your report is that there are significant variations among the various funds in the category. You segment it into four key flavors of emerging-markets bond funds. Let's take these one by one and discuss them in terms of their pros and cons. Let's start with what you call the hard-currency funds. What are those? What are the good things about them, and what are the potential risks?

Anderson: Hard-currency funds are basically the first type of approach that we saw in this space. We call them hard currency because these are emerging-markets bonds that are denominated in U.S. dollars or euros; so investors are getting exposure to the credits, the emerging-markets sovereigns and a little bit of corporates, but there is no foreign-currency exposure. So, you are taking on quite a bit of credit risk, actually, because a lot of the constituents in these hard-currency indexes are junk-rated. They are unable to issue bonds in their local currencies, which is why they have to tap the hard-currency market for that.

The second type that came about in the early to mid-2000s is local-currency-dedicated funds. As some of the more financially stable countries were having credit-rating upgrades, they began to be able to issue meaningful amounts of debt in their own currencies. I'm talking about Mexico, Russia--though, that has changed since--Brazil. Some of these countries started issuing enough that the market really moved forward, and it's growing actually the most quickly of all the markets.

And then you started to see some local-currency funds pop up. So, these are pure exposure to emerging markets in that you're getting exposure to the local interest rates as well as the local currencies. And with that, you get the most risk because that foreign-currency risk adds a lot of volatility to these funds--really about twice as much as a hard-currency offering. So, investors should be particularly careful when considering those. But on the plus side, they do offer more diversification away from the dollar.

The third type is emerging-markets corporate funds. This is the smallest group, but the emerging-markets corporate space has grown quite quickly in the past five years. So, I think it's certainly something to keep an eye on. These funds are just offering exposure to emerging-markets corporate bonds. Here, too, though, you're not really getting any foreign-currency risk. These emerging-markets corporates are typically denominated in U.S. dollars. So, that currency volatility comes out of the equation, but you are taking on credit risk at the company and country levels in some instances.

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Benz: The fourth type is a fund that would actually blend all three of the different varieties, and that's the type that you favor. Why is that that you think a blended emerging-markets bond fund is better than one that maybe takes a narrow subsection of emerging markets?

Anderson: Well, emerging-markets bonds are still a niche asset class. So, if an investor is going to really take the time to pick out one of these funds, we think it makes the most sense to pick one that's going to offer an array of exposure to the asset class. So, with that, you'll be getting some currency exposure, some corporate, and then, of course, the government debt. So, we at Morningstar think this is a good way to go if you want a dedicated emerging-markets bond fund.

Benz: And you do have a couple of favorite funds within that blended realm. Let's talk about them. TCW Emerging Markets Bond (TGEIX) is one of your favorite.

Anderson: That's right. That's a Silver-rated fund, and we like that one in particular because the managers and the team behind it have been investing in emerging-markets bonds and trading them since the 1980s. They have focused on all parts of that space--hard currency, local currency, and corporates--over time and they have specialists looking at each area. So, we think that's really key as the space has become more popular. We've seen fund companies launch funds recently, launch funds dedicated to each part of the market, and they just don't seem to have the teams and expertise behind them, whereas we think that that is true with TCW Emerging Markets Income. It's done well in a variety of environments, notably lately by playing down the local-currency market because emerging-markets currencies have really struggled lately.

Benz: And T. Rowe Price Emerging Markets Bond Fund (PREMX)--I know that one has been around for a long time. That's another one that you like.

Anderson: Absolutely. We like the same things there in that the team behind it has been managing through the evolution of this space, and the mandate for that fund broadened similarly to take on more local and corporate exposure. We think it's done that in a measured and sensible way. And it's done so successfully. It's a little more toned down in that it doesn't hold quite as much corporate or local-currency exposure; but, again, it gives people a wide variety of exposure to the space.

Benz: So, let's talk about fund flows. You noted in your report that investors have historically mistimed their purchases and sales of emerging-markets bonds. Let's talk about how investors could possibly do better on that front. What should they keep in mind when building out an allocation to emerging-markets fixed income?

Anderson: Given how much these types of funds have been yielding, surely these have been very tempting tools for people to boost yield, boost income in their portfolios. But what we found is that, over 10 years, the typical investor has missed out on about a third of gains that these funds have experienced. So, it really argues for a strategic allocation rather than a tactical one. We think that, given all the volatility that these funds experience, you really need to have a long-term outlook in order to benefit from both the bond and the currency returns.

Benz: And you say investors should also take a look at what they have in their portfolios before they add a dedicated allocation to emerging-markets fixed income because it may already be there. These bonds are increasingly popular in general bond funds. Let's talk about that phenomenon and why that's happening.

Anderson: Yes, that's a very important first step in determining how much exposure you want to take on. What we've seen in the world-bond category, in particular, is a marked increase in emerging-markets allocations. So, it's quite common to have 10% or 15% in emerging markets in a global-bond fund. That's actually about the allocation that's in the Barclays Global Aggregate right now. There are many world-bond funds that have 30%, 40%, or 50% in emerging markets.

So, it's not likely that an investor with that amount would need to take on a dedicated emerging-markets fund as well. The multisector space as well has seen an increase in inclusion of emerging-markets bonds. A lot of times in these funds that are set up with a higher-yielding mandate, you'll see 20% or 30% emerging markets in multisector-type funds. You're even seeing some core bond funds that will have single-digit stakes in, say, Mexico or Brazil. It's for yield, perhaps currency diversification as well.

Benz: So, among those funds that are more broadly diversified--either maybe a global-bond fund or a multisector fund--do you have any favorites that have historically done a pretty good job with emerging-markets fixed income?

Anderson: Absolutely. Templeton Global Bond (TPINX) is a Gold-rated world-bond fund. Emerging markets have played a very prominent role there for really the past decade. They've been about 50% of assets lately, and the team there has done a great job at picking its spots. They're very valuation driven and they're also making active currency bets, which have worked out very well there.

Legg Mason Brandywine Global Opportunities (GOBIX) is another one that stakes a significant amount in emerging-markets bonds, including the local currencies; you're probably looking at 30% to 40% of assets there. Others include Loomis Sayles Global Bond (LSGBX)--a bit more toned down lately and in general, at maybe 20% of assets. But there you're also getting currency exposures. And we've also seen PIMCO Global Bond (PIGLX) increase its allocation in emerging-markets bonds in the past few years to as much as a third of assets at times.

Benz: So, your message is to know what you own before you go there and certainly understand the risks.

Anderson: Absolutely.

Benz: Karin, thank you so much for being here.

Anderson: Thank you.

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