Put off by the paltry yields on Treasuries, many investors are turning to emerging-markets sovereign debt for better returns.
Since early June, investors have poured $1.3 billion into emerging-markets-debt funds, according to Lipper Inc., compared with the $1.1 billion that they invested in intermediate U.S. government funds. In recent weeks, the contrast has become even more marked, Lipper noted.
As financial safety became the dominant concern in the United States, investors flocked to Treasuries, driving down interest rates in the process. A 10-year U.S. Treasury note, for example, now yields 2.6%.
Yields on emerging-markets debt, by contrast, are much higher. A Brazilian 10-year note was priced to yield 11.4% as of last Thursday and an Indonesian 10-year 8.2%.
For a financial adviser considering appropriate asset allocations, the decision of whether to put money into emerging-markets debt starts with a simple question, said Ronald Albahary, chief investment officer of Convergent Wealth Advisors, a subsidiary of City National Bank with $13 billion in assets under advisement.
“The first question to ask oneself is whether deflation is a purely developed-world phenomenon, with the emerging world continuing to experience growth, or will the deflationary forces in the developed world infect the emerging world?” he said.
Mr. Albahary and his firm have decided that the U.S. and emerging-markets economies will be “decoupled.”
“Our feeling is that deflation is going to be primarily a developed-world phenomenon, which means that if you're looking for areas of investment that may work even if the U.S. is headed for an extended period of deflation, you need to look beyond the developed world for opportunities,” he said. “Today, we are favoring emerging-market debt over emerging-market equities because the debt provides us with a better risk-adjusted return.”
One key statistic that investors should consider — especially in a deflationary period, when debt service becomes more expensive in real terms and therefore more onerous — is the ratio of a country's debt to its gross domestic product, advisers said.
According to International Monetary Fund projections, the ratio of gross debt to GDP in the United States will reach almost 110% by 2015. By contrast, Brazil's debt-to-GDP ratio will be about 54% in five years, and Indonesia's will be 23%, the IMF estimates.
Although few investors expect any developed nations to default, they are keeping an eye on the pace of growth.
“The story that's clearly developing is one of young, working-class populations in emerging countries with low debt levels — and they're starting to spend,” Mr. Albahary said. “What's also interesting is that the emerging world is exporting more to each other than they are to [developed markets], which supports the thesis of a decoupling of the developed and emerging worlds.”
Greg Lester, portfolio manager of Bessemer Trust Co. NA's Global Opportunities Fund, agrees with the opportunities in emerging-markets bonds.
“When we look at government debt, we're always comparing and contrasting the yields versus the fundamentals,” he said. “I just don't know why you would want those low yields from a Treasury bond in the developed world when you can get much higher yields — and in our estimation, an improving economic story — in Indonesia, Malaysia or Brazil.”
To be sure, foreign investments carry their own risks. For example, investors take on currency risk when they buy debt denominated in local currencies, said Stephen Freedman, global investment strategist at UBS AG's wealth management segment.
“From an international perspective, the only place where you really ... reach for yield without concern for currency movements is if you invest in emerging-market debt denominated in dollars,” he said. It is a plan that Mr. Freedman recommends.
In addition to currency risk, Mitch Stapley, chief fixed-income officer at Fifth Third Asset Management Inc., said that he is concerned about the political risks in emerging-markets countries as well as the liquidity of their markets.
“After 2008, you really have to take liquidity into consideration,” said Mr. Stapley, whose firm oversees $13 billion in assets. “Emerging markets are going to be some of the first to freeze up in a crisis.”
Acknowledging those risks, advocates of emerging-markets debt think that the growth potential of the countries, which in time should translate into stronger currencies and higher bond prices, outweighs the negatives.
For Mr. Lester, it all comes back to the risk-reward question.
“Do I really want to buy something with a 2.6% yield for 10 years?” he asked rhetorically.
“I just don't see the value” in Treasuries, which could lose value fairly quickly and dramatically if interest rates rise, Mr. Lester said. “I do see the value in some other countries with higher rates, much better fundamentals and better growth prospects.”
E-mail Hilary Johnson at -firstname.lastname@example.org.