4 Top Funds for Investing in Emerging-Markets Debt

Emerging-markets bonds have been on a tear so far in 2016, with the typical fund in the emerging-markets bond fund group gaining nearly 8% for the year to date through late June.

That rally has sent yields in emerging-markets bonds down a bit, but they're still relatively attractive--in the neighborhood of 5% or 6% for many emerging-markets bond funds currently.

The fundamental prospects for the sector also look good, according to at least one major player in the emerging-markets bond arena. Speaking at the Morningstar Investment Conference in Chicago last week, portfolio manager Michael Hasenstab said he views local-currency-denominated emerging-markets debt as quite undervalued at today's levels. He doesn't believe all emerging markets are equally attractive--he thinks Turkish bonds are quite pricey, for example--but he called out Brazilian and Mexican bonds as especially cheap right now.

Of course, Hasenstab has long favored emerging-markets debt for his global bond funds, which include the Gold-rated

--an annual confab where the firm formulates its opinions on various parts of the economy and market--was that emerging markets afford interesting opportunities today, in part because of stabilization in the commodities sector. In a similar vein,

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But even as some market-watchers are expecting strong returns from emerging-markets bonds, no one is expecting those gains to be pain-free. For example, Research Affiliates' return/volatility graph depicts the fact that it is expecting substantial volatility in the asset class over the next decade, especially from the subset of bonds denominated in local currencies. High volatility has certainly been a feature of emerging-markets bonds in the past: Over the past decade, the typical emerging-markets bond fund has posted a standard deviation that's three times higher than that of the Barclays Aggregate Index (of high-quality U.S. bonds).

From a volatility and correlation standpoint, the typical emerging-markets bond fund is more closely aligned with the equity market than it is with the bond market. In 2008's equity-market rout, for example, the typical emerging-markets bond fund lost about 18% of its value. Stocks lost twice as much, but emerging-markets bonds didn't serve the shock-absorber role that bonds often play in equity-market sell-offs. Investors should bear that in mind when deciding whether and how to use emerging-markets bonds in their portfolios: They're exceptionally unreliable as ballast and best used in small doses. Investors should also have a nice, long time horizon for owning them.

Investors who are intrigued by the emerging-markets bond sector--and by the funds' still tantalizing yields of nearly 6% or more--should also be aware that the emerging-markets bond category is a broad basket: There are government and corporate emerging-markets bonds as well as those denominated in dollars and those denominated in local currencies. Those differences will have a major impact on a fund's risk/reward profile, as senior analyst Karin Anderson discusses in this video.)

Finally, it's worth noting that investors needn't own an emerging-markets bond fund to have exposure to the sector; many world-bond funds have substantial emerging-markets exposure, as do funds in the multisector, nontraditional, and intermediate-term bond groups. (Intermediate-term bond funds are generally limited by charter in how much they can put into emerging markets and other lower-quality parts of the market.) While Morningstar's fund reports don't break out emerging-markets bonds as a separate sector, investors can get a sense for general bond funds' emerging-markets exposure by looking at their country weightings as well as reading portfolio-manager commentaries or Morningstar analyst reports.

What follows are some of Morningstar's best ideas for emerging-markets bond exposure, starting with pure plays then moving on to global funds that have historically emphasized emerging markets to some extent. (Premium Morningstar.com users can view the complete list of emerging markets and world-bond picks

.)

Emerging-Markets Bond Specialists

Analyst Rating: Silver

Anderson notes that this fund's focus on bonds denominated in U.S. dollars has distinguished its performance pattern relative to emerging-markets bond funds with a heavier emphasis on local-currency-denominated debt. For example, she notes that the fund lost less than its peers when emerging-markets currencies swooned in the third quarters of 2011 and 2015. Yet she warns that the fund is not for the faint of heart, as longtime manager John Carlson has the leeway to hold some local-currency-denominated debt and will also take on credit risk when he thinks such risk-taking is being rewarded. Anderson gives the fund plaudits for its reasonable price tag, long-tenured manager, and sensible take on a volatile market sector.

Analyst Rating: Silver

Whereas some funds in the emerging-markets bond space have narrow mandates--focusing on local-currency-denominated emerging-markets bonds, for example--Anderson likes that this offering is relatively well-diversified. Management invests in local-currency and dollar-denominated debt, as well as sovereign and corporate bonds, a flexibility that this experienced management team has put to good use over the years. Like the Fidelity fund, this one is by no means tame; not only has it tended to emphasize corporate bonds more than most of its peers, but the portfolio's stake in bonds rated below investment grade also sets it apart. Thus, it can be vulnerable in credit-driven sell-offs.

World Bond Funds with Heavy Emerging-Markets Stakes

Templeton Global Bond

TPINX

Analyst Rating: Gold

Within the world-bond group, this fund's portfolio couldn't be more distinctive. As noted above, Hasenstab has long emphasized emerging-markets bonds at the expense of developed; he has also employed bets against the euro and yen. Wary of inflation, Hasenstab has recently maintained an ultrashort duration here. That willingness to maintain a distinctive-looking portfolio has led to a similarly idiosyncratic performance pattern: While its bets have been rewarded over Hasenstab's tenure here, the fund is usually at the top or the bottom of the world-bond group in any given year.

Analyst Rating: Silver

Like the Templeton fund, this world-bond offering downplays developed-markets bonds and emphasizes those from emerging markets. Its returns have been similarly volatile; not surprisingly, it thrives in market environments that reward risk-taking and looks weak in "risk-off" markets. But Anderson notes that the experienced management team in place here has taken good advantage of the fund's flexible charter; she thinks it's a solid choice for investors who go in with their eyes wide open to the risks of the fund's strategy.