Financial advisers find value in emerging-market debt funds

Your parents probably taught you many valuable lessons as a child, such as “Don’t talk to strangers,” and “Never get in the orangutan cage while drunk.” And, if you’re a financial adviser, they probably also told you not to reach for yield.

Which brings us to emerging-market debt funds. While these can offer high yields, relative to corporate bonds and Treasury securities, they can also offer unique risks, such as hyperinflation, civil war and exotic disease outbreaks. Are they worth the risk? Quite probably, in small amounts — but you have to choose carefully.

Investors poured $4.2 billion into emerging-market debt funds from June 30 through the end of August, according to Morningstar. A full $1.4 billion came into the funds in August alone. The basic reason is simple: Bond yields in developed countries are extraordinarily low or even negative. The Swiss 10-year government bond yields -0.41%, for example, and Japan’s yields -0.3%.

“Emerging-markets debt funds offer competitive yields and diversification,” says Todd Rosenbluth, director of ETF & mutual fund research with S&P Global Market Intelligence. And how: The average emerging-market fund sports a 12-month yield of 4.30%, according to Morningstar, versus 1.89% for the average U.S. government intermediate-term bond fund.

Given the relatively small size of some emerging-market debt markets, the torrents of money flowing into the sector have been like filling a soda bottle with a fire hose. So far this year, emerging-market debt funds are up an average 12.37%, including reinvested dividends.

But it’s not all just yield hunger. “The fundamentals in key countries have gotten better,” said Michael Conelius, lead manager of T. Rowe Price’s Emerging Markets Bond and Emerging Markets Corporate Bond Strategies. “While the very cheap assets have played out, there are still bonds earning 4% to 7% yields in countries that are stabilizing fundamentally and getting their fiscal houses in order.”

One example: Brazil, whose 10-year government bond yield has fallen to about 12% from 16% at the beginning of the year. (Bond prices rise when interest rates fall, and vice-versa.) Another country Mr. Conelius likes is Mexico, noting that Republican nominee Donald Trump “is a clear and present danger for Mexico, and the market’s trading their debt that way.” But the country’s underlying fundamentals are good, he added.

Like corporate bonds, emerging-market bonds can also benefit from credit upgrades. Hungary’s sovereign debt was recently upgraded to investment grade, opening the door for many institutional investors to buy their bonds. Mr. Conelius thinks Indonesia’s debt will also make investment grade soon.

Most bonds that emerging-market debt funds trade in are denominated in dollars, rather than local currency. Not only does that eliminate currency risk, but also makes the bonds more liquid. Nevertheless, dollar-denominated emerging-market debt represents the best value now, precisely because many investors avoid them, said Tina Vandersteel, a portfolio manager with GMO’s emerging-market debt team. “We find the local currency debt attractively priced for dollar-based investors at these levels,” she said. “You take more volatility risk, but we’re a valuation-based manager.”

And, while emerging-market bond prices have soared, they come from a low base: The group was crushed in 2015, falling an average 6% with reinvested interest. The bonds are still reasonably priced because “2015 was lousy year,” Mr. Rosenbluth said.

The problem with emerging-market bonds is the problem with emerging markets generally. They tend to be less stable than developed countries, for one thing. Consider Turkey, a NATO member with a generally stable economy until July 15, when an attempted military coup sent their bond yields up nearly a full percentage point. Similarly, Russia’s interest rates nearly doubled, to 16%, thanks to its annexation of Crimea and military activity against Ukraine. (The Russian 10-year yield has since fallen to nearly 8% this year).

And, of course, there are fears that global reaching for yield as gone too far. “What worries us is the endless hunt for yield,” said Chun Wang, portfolio manager for the Leuthold Group. “It’s getting a little too stretched, and all these interest rate sensitive sectors are all contingent on global interest rates being lower for longer. At some point, we would think that there’s an end to low rates, and that’s the biggest overall concern.”