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Our Top Emerging-Markets Bond Fund Picks

Morningstar analyst Karin Anderson discusses what's driven performance this year and why investors should consider the category.

Karen Wallace: Funds in the emerging-markets bond categories have been pretty volatile so far this year. But emerging-markets bonds in local currency have beaten every other taxable bond category over the trailing 12 months owing to stellar performance in 2017. Here to discuss some of the performance drivers and some of our analyst picks in the category is Karin Anderson. She is an associate director in our fixed-income manager research group.

Karin, thanks so much for being here.

Karin Anderson: No, problem, Karen. Thanks for having me.

Wallace: First, let's discuss a little bit about emerging-markets bonds. It sounds risky. What are some of the risks there?

Anderson: It's definitely one of the more volatile pockets of the fixed-income market. Investors in these types of bonds are going to be going after either credit or currency risk or both. It just depends on which types of bonds you are investing in. The two main areas are hard currency bonds, which are bonds that are denominated in U.S. dollars. There, you are not taking the currency risk, but you are actually going after quite a bit of credit risk because many of the countries in that index are below investment-grade. Some notable ones there would be like Venezuela or Ukraine that have been below investment-grade for quite some time and have gone through defaults in the past five years. While you are not getting currency volatility, you are courting quite a bit of credit risk.

On the other side of the coin are emerging-markets local currency bonds. There, you are actually buying the bond denominated in, say, Mexican pesos or Russian rubles. With that, you are getting a lot of volatility because of that EM currency exposure, typically, on the order of twice as much volatility as the hard currency group. It's a question of how much diversification but also volatility do you want to take through those currencies.

Wallace: Morningstar breaks out emerging-markets bonds in two separate categories, one denominated in local currency and the other denominated in U.S. dollars. Is that correct?

Anderson: Exactly right. For a long time, we had one category, because it was a small category for quite a while. But as the investment landscape has changed, we have seen a lot more EM local bond funds come to the market. We spun out the EM local bond group which makes very good sense for investors because of that volatility that I mentioned earlier. The EM bond group that contain some of the oldest funds in the category are more focused on hard currency denominated sovereign bonds or corporates.

Wallace: An emerging-markets bond allocation might not make sense for every investor. Who should think about an emerging-markets bond fund and how would it sort of fit in with a portfolio?

Anderson: An investor with a very U.S.-focused bond portfolio could certainly consider it. If they feel a little bit skittish about the currency volatility that can come with it, a hard currency allocation can make a lot of sense. Investors that are looking for even more diversification--a great example of that is, as you noted, EM local currency has strongly outperformed EM hard currency and other bond categories over the past year, EM local currency is a great way to get it. Still another way is to invest in blended funds that invest across the EM bond spectrum. They will have a bit of USD-denominated exposure, some of that local currency exposure, quasi sovereigns, like Petrobras or Gazprom, and then also, maybe a bit of EM corporate exposure. That gives you a bit of everything.

Now, all that said, investors need to take a hard look at their portfolios to make sure they don't already have a lot of EM bond exposure in, say, their global bond fund, their multisector fund and even some core funds like PIMCO Total Return have smaller allocations to EM bonds these days. It's becoming more and more common. Investors need to take a good look before they actually go out and pick a dedicated EM bond fund.

Wallace: That's a great point. What are some of the analyst picks in the EM bond category? What are some of the interesting approach that people take to mitigating the sort of risk or finding opportunity?

Anderson: One of our top choices in that blended group that I described is TCW Emerging Markets Income. They have invested across the EM bond spectrum for years, and the managers there have done a good job allocating risk and anticipating when it's a good time to take up that EM currency exposure and when to take it down. They navigated difficult period of 2013 to 2015 roughly for those currencies pretty well. They still lost money but lost less than most. They have a good history of picking corporates as well, which is a growing part of that investment landscape. That's one that we like that kind of gives people a broad-based exposure.

More old school funds would be Fidelity New Markets Income, T. Rowe Price Emerging Markets Bond, which are really more anchored in hard currency denominated debt. They are going to have very little currency risk but some significant credit and country risks at times. The T. Rowe Price fund, for example, had a very significant stake in Venezuela, and I believe still continues to do so. There, you are getting more of a U.S. high-yield-type exposure. You might want to think about that too if you already own a high-yield bond fund before adding something like that into the mix.

Wallace: Great. Thanks so much. It is an interesting topic. Thanks so much for being here to discuss it.

Anderson: Thank you.

Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.

Karin Anderson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.