From the October 2008 issue of Wealth Manager Web • Subscribe!

EMERGING MARKET DEBT

With credit markets in turmoil, many bond funds suffered losses in the first quarter of 2008. High-yield municipal funds dropped 3.10 percent, while ultra-short bond funds declined 1.91 percent, according to Morningstar. But emerging market bond funds stayed about flat. The stability represented a big change from the 1990s when emerging market bonds periodically collapsed at any sign of trouble in the U.S. or around the world.

Since suffering a double-digit loss in 1998, emerging market bonds have recorded a powerful rally. During the 10 years ending in June 2008, emerging market bond funds returned 11.15 percent annually--ranking as the top performer of the 19 bond categories tracked by Morningstar.

Their strength can be attributed to big changes in the emerging economies. In the past, many countries in Latin America and Asia faced severe budget deficits and heavy debt burdens. Most emerging government bonds were rated below investment grade. But in recent years, countries throughout the emerging markets have tightened their belts, reducing government spending and paying down debt. Rising exports of commodities and manufactured goods have enabled emerging countries to amass big stockpiles of foreign currency reserves. Now the government bonds of countries such as Brazil and Mexico are considered investment grade.

After the long rally, emerging market bonds no longer sell at bargain-basement levels. But many analysts argue that the securities are not yet overpriced. Funds in the category yield more than 7 percent--a tempting payout at a time when 10-year Treasuries yield only around 4.1 percent. And as their recent performance demonstrated, emerging market funds can help to diversify a portfolio, since the bonds do not always move in lockstep with Wall Street.

Which emerging bond fund makes the best choice? To find a winner, we turned again to the eight-part screens developed by FI360, a consulting firm in Sewickley, Pa. FI360's due-diligence process seeks funds that are at least three years old and have a minimum of $75 million in assets. Three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must also surpass category medians. The expense ratio must fall below the top quartile, and at least 80 percent of the fund's holdings must be consistent with the category.

The screens reduced the field from 70 down to eight contenders. The top finisher was SEI International Emerging Markets, but we eliminated the fund because it requires a minimum initial investment of $100,000. Other top finishers were MFS Emerging Markets Debt and Fidelity New Markets Income. In the end, we awarded the title to T. Rowe Price Emerging Markets Bond, which had among the best performance records and a high alpha.

T. Rowe Price achieved its record by maintaining a broadly diversified portfolio, holding debt from countries around the world. Portfolio manager Mike Conelius mostly owns government debt from solid countries. But he spices up the portfolio with contrarian plays that most competitors shun.

Noteworthy holdings include Iraqi bonds, securities that few funds hold. "Most portfolio manager hate Iraq bonds," says Conelius. "But the country has the capacity to make interest payments on its debt."

Conelius says that Iraq exports 2 million barrels of oil a day. That is producing a flood of cash, enabling the country to run a hefty budget surplus and pay interest on its debt. At a time when violence is declining in Iraq, prospects are good that oil exports will continue increasing. Meanwhile, the bonds yield a rich 9 percent.

Conelius scored big gains in recent years by holding bonds of several Eastern European countries, including Poland and Bulgaria. Though the economies looked shaky, the Eastern Europeans were racing to put their fiscal houses in order so that they could join the European Union. As they tightened budget deficits and increased exports, bond prices rose.

Currently, T. Rowe Price holds bonds from Serbia, which had been ravaged by war. Conelius figures that the country is committed to joining the EU and will modernize its economy, a process that should raise the bond prices.

Another unloved holding is a Jamaica government bond. Although it is one of the most heavily indebted countries in the world, Jamaica has never defaulted on its debt, Conelius says. Most of the bonds are bought by Jamaicans who loyally hold the securities until maturity. "There is an entrenched investor base that supports bond prices," says Conelius.

The fund's biggest position is in Brazil. Some bonds from the country yield 15 percent--a rich payout. Brazil is running a budget surplus. Expanding oil production should continue to prop up the bonds. "There have been major oil finds in Brazil, and the country is increasing its energy exports," Conelius says.

While T. Rowe Price typically keeps most assets in government bonds, the fund currently has 15 percent of the portfolio in corporate issues. Conelius says that some corporate bonds have been depressed because investors fear that a slowing global economy could lead to more defaults. He is particularly keen on issues from banks in Kazakhstan, the central Asian nation that is benefitting from oil sales. Many banks are expanding in the country to serve growing consumer markets, and the bonds yield more than 10 percent.

To be sure, issues from Kazakhstan and other emerging economies come with risk. But bonds of many countries have entered a new era when they can provide relatively steady income and competitive long-term returns.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a New York-based freelance business writer and a longtime regular contributor to Wealth Manager.

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