Have Emerging-Markets Bond Funds Emerged?

The trend hasn't been limited to dedicated emerging-markets portfolios, either. Managers of intermediate-term bond funds--which often form the core of investor portfolios--have been more likely to hold some assets in emerging-markets debt than ever before. The trend isn't universal, but the highest-profile examples are notable. The industry's largest fund, the $263 billion PIMCO Total Return (PTTRX), held 8% in the sector as of June, for example (a weighting that alone equates to one third of the emerging-markets bond category).

The Bull Case
It's clear that many investors have been favoring the sector as an alternative to domestic options whose yields are being held down by tight Federal Reserve policy, and to some degree slow growth and periodic flights to the quality of U.S. debt. Money managers such as PIMCO also make the case that emerging debt markets are more attractive than traditional developed-markets sovereigns, in particular, thanks to stronger underlying fundamentals. The news is awash with stories about high debt levels among advanced economies, but for emerging-markets enthusiasts the real story is just how much lower--and declining--those countries' debt and deficit levels are.

Emerging-markets economies also generally boast healthier levels of growth according to data from the International Monetary Fund, which estimates that they will grow some 5.4%, on average, in 2012 versus an anemic 1.2% for developed economies.

There's much more liquidity today given that the pool of emerging markets debt has grown sharply--Barclays' Global Emerging Markets Bond Index has more than doubled in size over the past 10 years--along with the improving credit picture among many sovereign and corporate emerging-markets issuers. Meanwhile, the mix of issuers is much more diverse today than it was just 10 years ago. At that time, well over half of emerging-markets corporate debt hailed from countries in the Americas according to Morningstar index data, for example, with modest issuance in Asia, Eastern Europe, the Middle East, or Africa. Today, the market's composition is more evenly distributed with roughly a third coming from Asia, a third from the Americas, and a third from Eastern Europe, the Middle East, and Africa.

Ready for Prime Time?
If you listen long enough, the case for emerging-markets bonds is convincing. Even taking those positive trends into account, however, the question remains as to whether emerging-markets debt has come far enough to make it an actualsubstitute for--or more of a supplement to--traditional, high-quality domestic bond allocations.

One issue is simply that of finding the right manager. Running emerging-markets bonds requires an arguably different set of skills and capabilities from those necessary for running domestic portfolios. You've got to have local knowledge and familiarity with the laws and corporate structures of an emerging market, argues OppenheimerFunds' director of fixed income, Krishna Memani, who also notes that each country often has different cultures and traditions that can have an impact on the fortunes of bond investors. Memani cites the experience of some managers when the Asian crisis led to losses in 1998: Several markets looked relatively safe and stable, but many companies didn't live up to their legal obligations to debtholders.

A more tangible issue is simply one of currency. While the credit risks of emerging-markets bond investing are arguably becoming more manageable, currency remains a tricky issue. That's especially true today when many funds are dipping into local market issues in lieu of the dollar-denominated debt that has historically dominated the sphere. Currency swings can often drown out regular bond-market movements, and currencies can easily zig when bond markets zag. JPMorgan's EMBI+ index (among the broadest measures of dollar-denominated emerging-markets debt) has soared more than 11% for the 12 months ending June 2012, for example, while the firm's ELMI+ index, which tracks emerging money markets in local currency, is down more than 7% over the same period.

In fact, potential volatility may remain the single most important issue for investors who have historically relied on their core bond portfolios to provide ballast in rocky markets. For all of the fundamental arguments in favor of emerging-markets bond investing, the fact is that those markets still court plenty of volatility.

The most recent stress test of any magnitude came during the third quarter of 2011, when worries over Europe's financial troubles boiled over. The incident triggered a global flight to quality and sent so-called risk assets tumbling. The average intermediate-term bond fund--which typically maintains meaningful exposure to U.S. government-backed Treasuries and mortgages--eked out a 1.6% gain during last year's third quarter. By contrast, the average emerging-markets bond offering sank 6.5% during the period. Standard deviation figures tell the same story over the past one- and three-year stretches, with the emerging-markets bond category exhibiting volatility 2-3 times greater than that of the intermediate-term bond group. Those caveats aren't necessarily a reason to stay away from emerging-markets debt--the arguments in its favor remain compelling. For those worried that low yields in core U.S. markets should send them packing elsewhere, however, it's worth remembering that many of the risks inherent in such a decision remain quite real.

Eric Jacobson is Morningstar's Director of Fixed-Income Fund Research and an Editorial Director for Mutual Fund Content.