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The Safest Way To Earn High Yields From Emerging Markets

David Sterman

Over the past few years, I've written repeatedly about the compelling long-term opportunities presented by emerging markets. These economies possess superior long-term growth prospects but trade at a considerable discount to more mature markets in Europe and the United States. 

Still, it's hard to understate the importance of "long-term" in that outlook. Emerging markets are quite volatile and can quickly rack up short-term losses. Indeed, in recent weeks a number of emerging markets have tumbled sharply, in large part due to concerns of an economic slowdown in China that is dampening demand for exports in countries such as Australia, Brazil and South Africa. I wrote about the issue in this recent column.

For a while there, global investors were dumping emerging-market bonds just as fast as they were selling emerging-market stocks. Then a light bulb went off: Investors realized that bonds are a lot safer in a slowing economy -- for a pair of reasons.

Those two factors: strong government finances and a lack of currency risk.

Back in the 1970s and '80s, many emerging-market governments showed little competence when it came to managing their finances. Cash reserves often ran dry, and panics ensued. Moreover, emerging market finance ministers typically pursued populist spending policies, which eventually led to high rates of inflation due to poor resource allocation.

Over the past few decades, much has changed. Today's finance ministers often are selected based on their global economic experience, having served stints at places such as the World Bank or the International Monetary Fund (IMF). These officials now ensure that government cash levels are quite robust, and they take steps to beat back inflation whenever it emerges. Morningstar analysts note, "Today, many emerging markets have relatively favorable growth outlooks, healthy balance sheets, budget surpluses, and favorable demographics."

A key result: We saw many government bond defaults back in the bad old days, but in the past few decades, Argentina is the only major economy to default on its bonds. That aspect of risk in government bonds has been virtually wiped out.

Still, U.S. investors suffer whenever the dollar strengthens against other currencies, and that has been a big factor in recent losses in emerging market stocks. Bonds don't always carry such currency risk. Many emerging-market government bonds (known as "sovereigns") are denominated in dollars. 

Even with a recent rebound, emerging-market bonds have fallen roughly 10% in just a couple of months, which has pushed already impressive yields into high-yield territory. That makes this a fine time to give these three exchange-traded funds (ETFs) a closer look.

1. iShares JPMorgan USD Emerging Markets Bond (EMB)
Each of the 163 bonds in this portfolio is denominated in dollars, led by stakes in Russian, Brazilian, Turkish and Mexican bonds. The 30-day yield of 4.8% (as calculated by the Securities and Exchange Commission) is more than twice the yield you'll get from a fund focused on U.S. government bonds. Back in early May, that yield stood at just 3.6%.

2. Vanguard Emerging Markets Government Bond Index ETF (VWOB)
As a Vanguard fund, this ETF is a typically good deal: The 0.35% annual expense ratio leads the pack. This fund also only buys dollar-denominated bonds with a leading focus on Brazil, Russia, Mexico and Turkey. This fund was launched only a month ago, and Vanguard has yet to denote the 30-day SEC yield; look for it to fall in the 4% to 5% range.

3. WisdomTree Emerging Markets Local Debt (ELD)
Some investors prefer to retain currency risk, especially after the dollar has made a strong run, as it has recently. Any pullback in the dollar, and corresponding rebound for other currencies, would actually magnify gains for these bonds. For such investors, this ETF should hold great appeal, as the bulk of its bonds are denominated in local currencies. 

The fund's managers have taken an unusual approach, allocating roughly 40% of the fund to four countries that receive investment-grade ratings, another 40% to midtier-rated government bonds, and the remainder in riskier yet higher-yielding bonds. Malaysian, Indonesian, Mexican and Brazilian bonds make up the top four holdings. The 30-day SEC yield of 4.7% nearly matches the iShares JPMorgan ETF noted above.

4. Market Vectors Emerging Markets Local Currency Bond ETF (EMLC)
Like the WisdomTree bond fund, this ETF also has exposure to local currencies. The appeal here is a relatively high 5.5% 30-day SEC yield and a fairly low 0.47% expense ratio. Poland, Brazil, South Africa and Turkey make up the top holdings in terms of bond exposure. 

Risks to Consider: Emerging-market bonds fell a whopping 30% in 2008, more than twice the current pullback, though that was considered to be a unique economic era that is unlikely to repeat.

Action to Take --> The key distinction between these four ETFs is the currency exposure. Further global economic weakness this year could lead to an ongoing "flight to quality" into the U.S. dollar, which would hurt the returns of local currency bonds. But over the longer term, global trade flows suggest that the dollar is bound to decline over time, which would serve to help boost returns of the bonds denominated in local currencies.

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