Posted by on Mar 11, 2013 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig |  March 8, 2013 5:59 p.m. ET

When you reach for yield, think about how far around the globe you should stretch.

Lately, investors haven’t been able to get enough emerging-market bonds, issued by governments and companies in dozens of countries in Latin America, Europe, Asia and Africa. In the year ended Jan. 31, $28.7 billion poured into mutual funds and exchange-traded funds that specialize in emerging-market debt, on top of the $53 billion in assets they started with, according to Morningstar. That is the highest growth rate of any bond-fund category.

Such funds yield an average of roughly 4%, more than twice the yield on the Barclays Aggregate index of U.S. government and corporate bonds. So it is no wonder investors are scurrying to Peru, Kazakhstan and even Zambia for higher income.

But these are places only for the brave.

Bonds in emerging markets have a long, often dangerous, history. British investors were enamored of Latin American bonds in the 1820s—right before several Latin countries defaulted. Baring Brothers, the great merchant bank, had to be rescued by the British government in 1890 after overinvesting in Argentine debt.

What is different now is the credit quality of these bonds. As credit ratings for the U.S. and Europe have fallen, emerging countries have been upgraded. Their economies generally are booming, and their borrowing is under control.

“You can’t deny that in a lot of these countries the fundamentals are super-strong,” says Nicolas Rohatyn, chief executive of the Rohatyn Group in New York, which manages $2.9 billion in emerging-market investments.

The bonds of developing countries used to act more like stocks. In 2008, the average emerging-market bond fund fell about 18%, while medium-term U.S. government bond funds gained 4.8%.

Now, however, bonds from developing countries with steadily improving economies “function more like safe havens,” says Pablo Goldberg, head of emerging-market research at HSBC Securities.

But the perception of safety has its price. Edgardo Sternberg, who manages roughly $800 million in emerging-market debt at Loomis Sayles in Boston, says the most popular emerging-market government bonds priced in dollars have risen so much lately that they have “nowhere to go.”

Consider the bonds due in March 2023 issued by the government of Colombia. They yielded 3.1% as of Friday. Colombia has recently been upgraded by all three major credit-ratings firms, and its economy is expected to expand by at least 4% this year.

But that yield on the Colombian bonds is just 1.1 percentage point more than the 2% you get on bonds of similar maturity issued by the U.S. Treasury, even though a Marxist rebellion has long simmered in Colombia.

Or look at bonds from the Russian government that are due in April 2022. They yielded 3.2% this week as of Friday. Russia is awash in oil money, and its government is far less indebted than Uncle Sam.

Still, Russia defaulted on its debt in 1998. The April 2022 bonds yield only about 1.1 percentage point more than U.S. Treasury bonds maturing around the same time, although some investors are uncomfortable lending to a government they see as autocratic and capricious.

At such levels, Mr. Sternberg says, “there’s really nothing attractive” about bonds like these.

A recent study by Robeco, a Dutch investment-management firm, shows that emerging-market government bonds issued in U.S. dollars tend to fluctuate in value much the same way as U.S. high-yield corporate bonds.

Thus, if you already own a high-yield bond fund, emerging government bonds issued in dollars offer less diversification than you might expect, say Johan Duyvesteyn and Maurice Meijers of Robeco.

Mr. Rohatyn of the Rohatyn Group points out that with governments in Europe and Japan determined to depreciate their currencies, emerging markets are bound to benefit from better exchange rates.

That would make their government bonds—if denominated in local money—more valuable to U.S. investors. But such debt issued in dollars will remain vulnerable to any sharp rise in U.S. interest rates, he says.

Analysts say that in emerging markets, corporate debt is often more attractive than government bonds. Aziz Sunderji, a credit strategist at Barclays, says the valuations on emerging corporate bonds “are certainly not stretched” in general. The market, dominated by big global firms like Brazilian mining giant Vale and Russian energy company Lukoil Holdings, is approaching $1 trillion in outstanding debt.

Among the exchange-traded funds specializing in local-currency debt are iShares Emerging Markets Local Currency Bond, Market Vectors Emerging Markets Local Currency Bond, SPDR Barclays Capital Emerging Markets Local Bond and WisdomTree Emerging Markets Local Debt. All have annual expenses of no more than 0.6%, or $6 per $1,000 invested. As issuers from “frontier” countries like Azerbaijan, Bolivia and Tanzania enter the market, check to make sure the holdings aren’t getting too exotic for your taste.

While the future for emerging-market debt looks bright, the past should give you pause. Invest in these bonds only if you know you are as brave as you think you are. Sooner or later, you are going to find out how much risk you can withstand.

Source: The Wall Street Journal,