Emerging-markets bonds will outperform other fixed-income categories, experts predict

If the bull market in bonds is coming to an end, emerging markets may be one place where fixed-income investors can take refuge.

Year-to-date through last Wednes-day, mutual funds that invest in emerging-markets bonds were up an average of 23.47%, making them the best-performing bond fund category behind only bank loan and high-yield-bond funds, according to Morningstar Inc.

And while 20%-plus returns are unlikely going forward, it is not unreasonable to expect emerging-markets-bond funds to continue to outperform most other bond fund categories, according to industry experts.

There are a number of reasons such bonds should continue to do well, said Claire Husson, a portfolio manager for fixed income at Frank-lin Templeton Investments.

Emerging-market economies are fundamentally stronger than in the past, said Ms. Husson, co-manager of the $89.3 million Franklin Templeton Emerging Markets Debt Opportunities Fund (FEMDX).

In response to the economic crisis, some of these countries have implemented “efficient” fiscal and monetary policies that do not carry as much risk of inflation as stimulus programs in the developed world do, she said.

INFLATION FEARS

“They have supplied liquidity, money to their local banking sector, but this step has been limited,” Ms. Husson said. “It’s not to the same extent it has been in the United States and Europe.”

And inflation is the enemy of bond buyers. It is expected to be the catalyst that brings down the decades-long bull market in bonds.

“There’s no place to go for [interest] rates but up,” said James Holtzman, an adviser with Legend Financial Advisors Inc., which has about $330 million in assets.

The exception is emerging markets.

“I would say that inflation is not the primary concern in emerging markets at the moment,” Ms. Husson said.

That doesn’t mean emerging markets won’t feel the effects of inflation.

“If we see inflation in the [United States] through trade channels, that could spread out to emerging markets,” Ms. Husson said. “However, if we observe inflation in the [United States], then some of that inflation pass-through will be offset by currency appreciation.”

Of course, emerging-market governments didn’t have to use monetary and fiscal policy to the extent that developed markets used them, said Matthew Ryan, a senior vice president with MFS Investment Management and manager of its $876.9 million MFS Emerging Markets Debt Fund (MEDAX).

Emerging-market banks weren’t as heavily involved in the complicated investment strategies that precipitated the economic crisis, he said.

“To some extent, they were innocent bystanders,” he said.

It makes them more attractive to investors.

“I think from a macroeconomic perspective, emerging markets are pretty solid compared to developed markets,” said Micah Porter, president of Minerva Planning Group, which has $45 million under management. “You can even make the case that they are less risky in some ways.”

A couple of weeks ago, he started putting some clients into the $2.4 billion Pimco Emerging Markets Bond Fund (PAEMX) from Pacific Investment Management Co.

Having some exposure to emerging-market bonds makes sense, said Lawrence Jones, an analyst with Morningstar Inc.

But investors need to be careful, because some emerging-market funds are riskier than others, he said.

For example, the Pimco fund takes a “cautious” approach to investing in emerging markets, Mr. Jones said.

It favors high-quality names and generally steers clear of riskier “frontier” countries, he said.

“While the strategy can prevent them from leading the pack, it often keeps them from being in the basement when emerging markets tank,” Mr. Jones said.

On the other hand, the $1.1 billion T. Rowe Price Emerging Markets Bond Fund (PREMX) from T. Rowe Price Associates Inc. takes more risk, he said.

Its philosophy is to “step outside” the more-established emerging-market countries and to invest in some of the frontier countries — a move aimed at providing uncorrelated returns, Mr. Jones said.

BUYER OF IRAQI DEBT

The fund was a “very sizable” buyer of Iraqi sovereign debt, based on the belief that the country will ultimately stabilize, allowing the use of oil revenue to cover the its debt, he said.

The different strategies have served both funds reasonably well.

Year-to-date through last Wednesday, the Pimco fund was up 21.89%, placing it in the 54th percentile of its emerging-market bond fund category; for the one-year period; it was up 3.80%, placing it in the 49th percentile; for the three-year annualized period it was up 4.59%, placing it in the 55th percentile; and for the five-year annualized period it was up 7.56%, placing it in the 57th percentile, according to Morningstar.

Also, year-to-date through Wednesday, the T. Rowe Price fund was up 25.77%, placing it in the 34th percentile of its emerging-market bond fund category; for the one-year period it was up 3.42%, placing it in the 54th percentile; for the three-year annualized period it was up 4.9%, placing it in the 47th percentile; and for the five-year annualized period it was up 9.21%, placing it in the 17th percentile.

Those aren’t bad returns, but Legend’s Mr. Holtzman said he is not tempted to buy an emerging-market bond fund.

Unless you have a strong conviction that emerging-market bonds will outperform — which he doesn’t — there is no reason to hold such a fund.

Junk bonds will “hold up better” because of the higher coupons they are paying, Mr. Holtzman said.

“Emerging-market bonds will probably fall apart sooner than high-yield,” he said.

E-mail David Hoffman at [email protected].