(FORTUNE Magazine) – Wall Street old-timers used to chuckle about ''Peruvian bonds'': broker slang for worthless securities. Nowadays owners of the Andean country's debt are the ones who are smiling. Loans that sold for as little as 20 cents on the dollar just over a year ago now fetch upwards of 70 cents. Thanks to such turnarounds, mutual funds that specialize in Third World debt have been posting spectacular returns.

Throughout the developing world, bond markets have cha-cha-chaed their way through 1993 as erstwhile basketcase economies have gotten healthy doses of free-market reform and inoculations against fiscal irresponsibility. Says Mark Arnold of the Bear Stearns Emerging Markets Debt fund: ''Developing countries have been forced to get their act together because they can't depend on either superpower support or rising commodity prices.'' Last year the Salomon Brothers Brady Bond Index -- which tracks developing-country government bonds that have been restructured under a program drafted by former Treasury Secretary Nicholas Brady -- racked up a total return of 44%. Part of that return comes from fat yields, ranging up to five percentage points more than U.S. Treasuries for some Brazilian bonds. But even higher- quality debt like many 30-year Mexican government bonds yield 1.5 percentage points more than their U.S. counterparts. More important, as economic reforms take hold in Latin America, Eastern Europe, and Southeast Asia, the perceived credit quality of these countries is improving, lifting prices and kicking in hefty capital gains. Mexico's BB+ rated government debt is expected to be raised to investment grade (BBB) this year. Says Wayne Lyski of the closed-end Alliance World Dollar Government fund: ''There's still substantial upside in Mexico. The rating agencies have been ridiculously slow in upgrading the country.'' While managers don't expect to duplicate 1993 returns, many think they can earn 15% or better in 1994. Should investors join the party? It depends first on your stomach for Third World political intrigue: A coup d'etat on CNN is one matter; losing a chunk of your retirement money while you watch is quite another. Warns chief emerging-market debt trader Roberto Verthelyi of Oppenheimer & Co.: ''You have to incorporate political risk into your expected return.'' It also means learning to tango with different kinds of debt. About 50% of emerging-market debt is in the form of Brady bonds, which are typically denominated in dollars, thus eliminating much of the risk of currency swings. In most cases, principal is collateralized by zero-coupon U.S. Treasuries, meaning that while it is safe, say adios to interest payments if the issuing country defaults. Because diversification is key -- and brokerage commissions for foreign bonds are high -- a fund is the only sensible option for most investors. But choosing a fund is no simple job: Since the first Brady plan debt restructuring was in 1990, no fund -- either open- or closed-end -- can boast a meaningful, long-term track record. Checking up on a portfolio manager's background is essential. Though the open-end Scudder Emerging Markets Income fund was just launched, co-manager Isabel Saltzman rang up a 36% return last year for its closed-end sister, the Latin America Dollar Income fund. Gauging a fund's portfolio for diversity is also wise. Says William McBride, international editor for Lipper Analytical Services: ''If 30% of a fund is invested in one kind of Brazilian bond, that's too much.'' And when it comes to higher-grade corporate bonds, make sure a fund isn't overinvested in a particular sector, like petroleum or utilities. All this information can be gleaned from the most recent quarterly reports. To be safe, limit your exposure. For conservative investors, that means a maximum 5% of a portfolio should be invested in emerging-market debt. For daredevils: 10%. Owners of high-yield or convertible bond funds should approach emerging-market bond funds with an added measure of caution. The convertible or junk bond fund they own may already have a big chunk of its assets in this type of debt. There are just a handful of open-end mutual funds specializing in this market, but even these have pronounced differences. The no-load Scudder Emerging Markets Income fund is investing in bonds with a variety of maturities, which provide both diversification and lower volatility. The fund also owns a healthy helping of depressed bonds, like those of Venezuela, which have been driven down by political turmoil. By investing in such bonds, manager Saltzman hopes to pick up extra gains and yield, and dampen her exposure to U.S. interest rate risk. Says she: ''The deeper the discount, the less the correlation to the U.S. market.'' Mark Arnold, manager of the nine-month-old Bear Stearns Emerging Markets Debt fund, cut his teeth on an offshore emerging-markets debt fund, where he earned average annual returns of 29% over the past two and a half years. By focusing on bonds with floating rates and shorter maturities, Arnold minimizes interest rate risk while still getting emerging-market bang. His largest holdings are in Argentina and Mexico, principally dollar-denominated, floating-rate bonds, accounting for 32% of the portfolio. Geographic diversification is key for Simon Nocera of the G.T. Global High Income fund, which returned 51% last year. Just half his fund is invested in Latin America, and no more than 15% in a given country. He now sees increasing opportunities in Eastern Europe and North Africa. Closed-end funds can provide some esoteric twists on the emerging markets. Some, like Salomon Bros.' Emerging Markets Income fund, borrow money against their debt to leverage returns. Net asset value rose 50% last year. Says Salomon money manager Peter Wilby: ''We magnify both our yield and our credit risk.'' That means potentially high, yet more volatile, returns. Wilby also mixes mortgaged-backed securities and Brady bonds in his four-month-old Salomon Bros. 2008 Worldwide Dollar Government Term Trust, and U.S. junk bonds with emerging-market debt in his 11-month-old Salomon Bros. High Income fund. Net asset values have risen 8.6% and 22.9%, respectively, since these funds were launched.

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