Finding Hefty Yields in Emerging Markets Bonds

TheStreet.com

NEW YORK (TheStreet) -- Emerging markets bond funds have been rallying. The funds returned 15.0% this year, outdoing the Barclays Capital Aggregate Bond LAG index by 11 percentage points, according to Morningstar. Investors have taken notice, pouring $19 billion into the funds this year, a huge inflow for a category with $73 billion total assets.

Can emerging bonds continue to deliver solid returns? Probably. The bonds pay compelling yields. At a time when 10-year Treasuries yield 1.65%, some emerging markets funds yield more than 5.0%. Besides paying rich yields, many countries in Latin America and Asia boast strong balance sheets. That has special appeal in an era when developed countries are plagued with huge debt burdens.

After struggling with financial crises in the 1990s, many emerging countries tightened their belts, reducing budget deficits and paying down debts. As a result, ratings agencies have upgraded many emerging countries, including Brazil, Turkey, and Russia, that were once considered below-investment grade. The upgrades have helped bond prices to rise sharply.

While the emerging markets improved their positions, the U.S. and Europe engaged in a borrowing binge. In response to the undisciplined actions, ratings agencies downgraded many developed countries, including the U.S., France, Ireland, and Austria, that once were considered AAA, the top debt rating.

Despite much talk about reform, debt positions of developed countries have continued deteriorating, says Dave Robbins, portfolio manager of TCW Emerging Markets Income TGEIX . At the start of the financial crisis in 2008, developed countries had debt levels that were equal to 80% of their gross domestic products. Since then the debt climbed to 110% of GDP. During the same period, the debt figure of developing countries declined from 35% to 34%.

The balance sheets of emerging markets will improve in coming years, Robbins says. With millions of consumers entering the urban middle classes in Asia and Latin America, the emerging economies should continue showing healthy growth and paying down debt. That should help to boost bond prices. The outlook is grimmer for the developed world, Robbins says. "In the next several years, there will be slow growth in the developed world because governments and consumers must repair their balance sheets," he says.

Funds that invest in emerging markets debt follow a variety of approaches. Some managers focus exclusively on bonds that that are denominated in dollars -- not in the currencies of the countries issuing the debt. Other funds emphasize bonds denominated in foreign currencies. In the past, many investors preferred the dollar bonds because they would not necessarily collapse if the foreign currencies fell. These days many investors favor local currency issues, which can strengthen as emerging markets grow.

To hold a broad collection of bonds, consider TCW Emerging Markets Income, which has returned 13.4% annually during the past five years, ranking as the top performer in the category. The fund yields 5.5%. TCW follows a wide-ranging approach, emphasizing dollar bonds some years and shifting to foreign currencies at other times. Lately the fund has been increasing its exposure to local currencies.

Portfolio manager Dave Robbins likes Brazilian currency issues that yield 9.75%. The bonds must pay the extra yield in order to attract investors who worry about the country's history of inflation. But Robbins argues that the inflation picture is better than the market expects. "Inflation rates have been coming down as the country's economic policy has improved," he says.

Another solid performer is Federated Emerging Market Debt IHIAX , which returned 10.1% annually during the past five years, outdoing 70% of peers. Federated can hold dollar or local currency bonds. These days the portfolio managers are emphasizing dollar securities. Portfolio manager Roberto Sanchez-Dahl concedes that many currencies appear sound. But he worries that local currencies can be volatile during periods when investors flee risky assets.

Sanchez-Dahl is particularly keen on government bonds from Peru and Colombia, two countries that have been upgraded to ratings of BBB, the lowest investment-grade rating. The bonds yield 5%, while comparable U.S. securities yield about 3.5%. "You can get a nice yield premium from BBB issuers in the emerging markets," he says.

A fund that holds a mix of government and corporate bonds is Goldman Sachs Emerging Markets Debt GSDAX , which returned 10.1% annually during the past five years. Portfolio manager Samuel Finkelstein has big stakes in investment-grade countries, such as Mexico and Turkey. But he is also willing to hold some below-investment grade issues. Favorite holdings include bonds from the Ivory Coast, which yield 7.3%. The country defaulted on its bonds several years ago when a civil war disrupted the economy. But lately peace has returned, and the bond prices have jumped 80% in the past year. "The country has come a long way and reinstated coupon payments," says Finkelstein.

For a fund that holds dollar and local currency bonds, consider Columbia Emerging Markets Bond REBAX , which has returned 10.8% annually during the past five years. The fund yields 5.0%. Portfolio manager James Carlen likes local currency Mexican bonds, which yield 5.5%. "Mexico has an independent central bank that has a strong focus on controlling inflation," he says.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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