From the December 2004 issue of Investment Advisor • Subscribe!

December 1, 2004

Emerging Market Debt Pays Off

Among the riskiest investments available to U.S. investors, emerging market bonds have delivered outsized gains over the past few years. The bonds have benefited from volatility in developed-country equity markets, leading to high cash inflows, and from investors' increased appetite for higher-yielding securities. Through the 12 months ended October 29, the average emerging markets bond fund gained 13.1%, while the S&P 500 Index rose 9.5%. Over the longer term, the outperformance is more dramatic: for the five-year period, the average emerging markets portfolio climbed 16.1% on an annualized basis, while the S&P 500 fell 2.2%.

A common misconception about these bonds is that they are of below-investment-grade quality. However, several developing nations, including Mexico, Malaysia, and Singapore, have seen their sovereign debt upgraded in recent years. Moreover, as emerging market bonds exhibit very low correlation with U.S. equity and bond markets, they could help to mitigate volatility in an investor's overall portfolio. Along with the higher risks come higher yield and higher potential price appreciation.

One of the sector's better long-term performers is the $1.66 billion Pimco Emerging Markets Bond Fund (PEBIX), which soared 20.6% (annualized) for the past five years. Managed by Mohamed El-Erian, the fund has significant positions in Brazil and Russia, two developing countries with solid fundamentals and attractive credit spreads relative to Treasuries. El-Erian has a somewhat conservative investment style by hedging against unfavorable currency fluctuations and buying intermediate-term bonds to help control risk.

Another long-term outperformer, the $150 million AllianceBernstein Emerging Market Debt Fund (AGDAX) takes a more aggressive investment strategy--lead manager Paul DeNoon often invests in high-risk, lower-rated bonds. The portfolio is spread across 24 nations, including such volatile markets as Venezuela, Turkey, and Argentina.--Palash R. Ghosh

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