Ukraine has lost a bit of the world’s attention in the past month as the most worrisome international hot spot for investors due to the boiling conflict in Iraq. But that doesn’t mean there aren’t opportunities in Mother Russia’s harried neighbor for exchange-traded fund (ETF) and mutual fund investors looking to emerging market bonds to potentially boost returns. (For more on this topic, see: An Introduction To Emerging Market Bonds.)

Emerging market bond ETFs and mutual funds buy bonds issued by the governments of fast growing economies of countries in Asia, South America and Eastern Europe, including Hungary and Ukraine. Countries issue the bonds in either local currencies or in debt that is dollar-denominated. Investor demand for emerging market debt has increased significantly over the last several years due to improving fundamentals in these countries and relatively higher yields. (For related reading, see: Should You Invest In Emerging Markets?)

Hunting for Yield

The U.S. Federal Reserve’s bond buying program has also boosted yield-starved investor interest in emerging market debt. The flip side to the Fed’s bond buying policy is tapering, and emerging markets are extremely sensitive to the taper. Concerns last year about the effect of the tapering of the Fed’s bond buying program caused extreme volatility in those markets. Emerging markets bond funds saw an average decline of 7% last year, according to fund tracker Morningstar.

A handful of ETFs and mutual funds provide investors with exposure much greater than their peers to Ukrainian dollar-dominated bonds. Many emerging market debt managers have avoided Ukraine due to fears of Russia's continued harassment. One longtime global bond manager, Michael Hasenstab, is taking a contrarian view on Ukraine, a country that has seen its fair share of turmoil in the past year. (For related reading, see: Investing Like a Contrarian.)

Pick Selectively

“Ukraine’s a country that we’ve been interested in for a number of years and we’ve picked our spots selectively,” Hasenstab recently said in an interview. “Over the last couple of years, Ukraine has gone through periods when they’re out of favor with the market and you’ve had panic selling and spikes in yields, and so we have cherry-picked those opportunities to accumulate a position.”

“What attracted us to it was – on the solvency side – Ukraine has very little debt,” said Mr. Hasenstab, who is the manager of the giant $72 billion Templeton Global Bond A fund (TPINX), which is up about 2% for the year. Its long-term performance is more impressive; for the past 12 months the fund is up 4.3%, while over five years it is up 13.6%.

“As a dollar-based investor, we’re not taking foreign-exchange risk, we’re taking dollar-denominated Ukrainian government bonds in a country that has 40% debt-to-GDP,” Hasenstab said. “It was never a solvency issue. It was more one of liquidity, and recently with the IMF package, international aid support, Ukraine will access over the next couple of years, because of their good reform agenda, over $30 billion of international assistance.

Hasenstab believes that the Ukraine’s recent crisis and Russia taking control of the Crimea has spurred economic reforms that – in three to five years – will improve Ukraine’s credit.

While Hasenstab draws attention for being enamored with such a hot spot, others do agree with his long-term assessment of Ukraine.

Bond Breathing Space

“Vital breathing space was given to the Ukrainian government at end of March, when a two year International Monetary Fund program with up to $18 billion was agreed as part of a wider international funding with the potential to reach $27 billion,” recently noted Aberdeen Asset Management. “It is expected that this amount should be large enough to stabilize the currency and the country’s banking system.”

And Hasenstab is making good on his belief in Ukrainian debt. TPINX has 7.3% of the portfolio’s bonds in Ukrainian debt; the average world bond fund has barely 0.57% allocated to Ukrainian debt, according to Morningstar. For even greater exposure to Ukraine, investors can take a look at another fund Hasenstab co-manages, the Templeton Emerging Markets Bond A fund, (FEMGX). That fund currently has 12.59% of its bonds in Ukraine, while the average emerging markets bond fund has just 1.3%. (For related reading, see: 4 Misconceptions That Sink Emerging Market Investors.)

A Pair of Funds To Consider

ETF investors interested in exposure to Ukraine should consider two funds, the iShares Emerging Markets High Yield Bond fund, (EMHY) and the Pro Shares Short Term USD Emerging Markets Bond ETF, (EMSH). With $206 million in total assets, EMHY has 2.6% of its bonds in Ukraine – about twice the average emerging markets bond ETF.

For investors who are more enamored with the argument to buy Ukrainian debt, EMSH may be a better fit, although it is tiny, with just $12.3 million in total assets. But with 8.7% of its bonds in Ukrainian debt, EMSH has six-and-a-half times the exposure to Ukraine than the average emerging markets ETF.

Emerging markets debt investors willing to increase or take on exposure to the Ukraine should have patience, according to Hasenstab. Ukrainian debt was trading in the mid-80s earlier this year but bonds have rebounded. Many are close to par now. “It’s a volatile market; it ebbs and flows on a day-by-day basis,” he said. “But I think we’ve seen a lot of naysayers – a lot of short-sellers out there – that have realized that was a mistake.”

“Our objective is to position for a three- to five-year horizon, when ultimately underlying macroeconomic fundamentals will determine market prices,” Hasenstab said. “We have the benefit of that long-term horizon, which allows us to ride through periods of short term volatility.”

The Bottom Line

Looking beyond current violence and unrest, Ukraine presents some compelling reasons for adventurous emerging markets investors who don't mind a little geopolitical risk. It's strong balance sheet means that once political stability returns, Ukraine could become an attractive destination for investors. The time to get in - and get in relatively cheaply - could be now.

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