Down, But Far From Out Why emerging-market bonds are not quite as risky as they sound.
By Lynn O'Shaughnessy

(Business 2.0) – Ecuador has defaulted on its debt more than any other nation. So why would you want to buy its bonds? Or, for that matter, those of Russia, where oligarchs and an ex-KGB agent wrestle one another for control of the economy. Here's one pretty good reason: You could make a killing.

Some of the best returns in the world can be found in the bonds issued by developing economies. It takes nerve, but if you had invested in emerging-market debt during the past 10 years, you would have made more on your money than if you'd ridden bets on tech stocks or even the stalwarts of the Dow. In fact, strange though it may seem, emerging-market bonds from places like Brazil, Bulgaria, Nigeria, and other global garden spots were the past decade's best-performing asset class.

Since 1994, J.P. Morgan's Emerging Markets Bond Index Plus, the benchmark for the category, has returned 10.5 percent annually, somewhat more than Nasdaq's 9.4 percent. When you compare emerging-market bonds with other kinds of bond funds, the performance gap widens. Morningstar says every one of the top 25 bond funds of the past five years was in emerging-market debt.

While many investors have a hard time believing that these securities aren't horribly risky, the biggest threat to such bonds isn't political uprisings--it's rising interest rates. As rates rise, bond prices fall. That's true for all bonds, of course, but emerging-market bonds are far more volatile than most. When rates in the United States started inching up this year, speculative investors got spooked that Latin America and Southeast Asia faced trouble. They bailed, forcing bond prices down quickly. The emerging-markets index has dropped more than 4 percent this year, and some money managers are worried about a repeat of the summer of 1998, when investors suffered a 34 percent loss.

Once again, the threat is exaggerated, says Mohamed A. El-Erian, who manages Pimco's well-regarded Emerging Markets Bond Fund. Since the debt crises of the 1990s, many governments have stronger fiscal policies, as well as more independent central banks and flexible exchange rates. These countries have also built up their international reserves, which can serve as shock absorbers during rocky times. And they've reduced debt.

Still, over the past 10 years, S&P 500 index funds have matched the returns of most emerging-market funds--with a lot less risk. So why even bother? Because an emerging-markets bond fund like Morningstar's top pick, the Fidelity New Markets Income Fund, often zigs when large-cap stocks, tech stocks, junk bonds, and Treasurys zag. Diversifying into emerging-market bonds can boost returns and dampen overall risk.

Just don't overindulge: Only 3 to 5 percent of a long-term investor's portfolio should be in emerging-market bonds, El-Erian suggests. Because of the current interest-rate volatility, Michael Conelius, manager of T. Rowe Price Emerging Markets Bond Fund, recommends transferring cash into this moving target gradually. "Emerging-market debt should complement your bond exposure," Conelius advises. "It should not be your bond exposure." After all, even though Ecuadoran bonds returned 179 percent during the past five years and Russian bonds 568 percent, you still want to be able to sleep at night. -- LYNN O'SHAUGHNESSY