It’s easy to understand the appeal of investing in emerging markets. After all, torrid economic growth coupled with rising middle class wealth has created some of the biggest stock market gains over the last few decades. The ascension of nations like China or Russia to world superpower status underscores investment in these developing nations.
However, they don’t call them developing for a reason.
Volatility and risk are hallmarks of these nations as evident by the annual return pattern of one of the sectors biggest funds - iShares MSCI Emerging Markets Index (ARCA:EEM). While the EEM has produced an average 16% annual return since its inception, that return pattern has been quite choppy. This includes 72% return in 2009 and 50% loss in 2008.
That pattern of boom and bust can scare-off some investors and leave their portfolios missing some oomph. Luckily, there is more than one way into the developing world.
SEE: Ways To Invest In Developing Countries
No Longer A Niche
While an investor might add Brazil through the iShares MSCI Brazil Index (ARCA:EWZ) as a capital gain component to acquire access to the nation's growing economy, equally as interesting are its bonds.
The emerging market bond sector continues to grow by leaps and bounds as more developing nations have begun to tap the credit markets. That’s producing plenty of opportunities for investors. At the same time, the number of options for tapping these bonds for regular retail investors has grown as well. According to Morningstar (Nasdaq:MORN) the number of mutual funds that focus on the sector has jumped to 75 from just 28 in only three years, and more than $21.3 billion in new cash went into these bond funds in 2012.
There’s plenty of reason why investors would want to take a stab at emerging market debt.
First, emerging market bonds trade at higher yields and risk premiums than developed market bonds with similar maturities. This is despite falling repayment and political risks as well as the fact that many emerging market nations have stronger balance sheets and lower debt-to-GDP ratios than their developed twins. Investors are essentially getting junk bond-like 5 to 8% coupon rates with actually lower default risk.
Secondly, bonds denominated in “local-currencies” offer higher returns if that currency gains against the dollar. Over the past decade, that currency appreciation accounted for nearly 17% of additional return on local currency emerging markets debt. That’s a huge perk as many analysts anticipate the dollar continuing its long term slide as inflation takes hold.
SEE: Play Foreign Currencies Against The U.S. Dollar And Win
Finally, emerging market bonds have the potential for lower portfolio volatility. Historically, the returns on emerging markets debt have shown lower correlations with those of many traditional asset classes- including emerging market equities. That makes them a powerful tool for both current income and growth.
Adding A Swath of EMD
Given the positives pertaining to emerging market debt, investors may want to add the sector to their bond portfolios. Their first decision rests on whether they want bonds denominated in dollars or local currencies.
Emerging market nations first began issuing debt denominated in U.S. dollars, which was done as a hedge. The general idea was that the greenback would be reliable protection if an issuing country began to falter- the dollar would hold it up. With $5.8 billion in assets, the iShares JPMorgan USD Emerging Markets Bond (ARCA:EMB) is the largest and oldest fund in the sector. The exchange-traded fund (ETF) currently tracks 168 different emerging market bonds including some corporate issues and currently has a 12 month yield of 4.22%. Slightly smaller, but higher yielding (currently at 4.79%) - the PowerShares Emerging Sovereign Debt (NYSE:PCY) makes an ideal choice as well.
While there have been some new entrants in the local-currency EMD space- like the SPDR Barclays Emerging Markets Local Bond (ARCA:EBND) -the actively managed WisdomTree Emerging Markets Local Debt (ARCA:ELD) is still the biggest and most successful fund. The ETF spreads its $1.9 billion in assets across bonds from nations like Mexico and Poland, with appreciating currencies. That could provide plenty gains as well as income opportunities. ELD currently yields 3.88%.
Finally, many emerging market companies have begun tapping the credit markets as well. Offering similar currency appreciation and yields, these bonds can be tapped via the SPDR BofA ML Emerging Markets Corporate Bond ETF (ARCA:EMCD).
The Bottom Line
For investors looking to avoid some of the volatility associated with emerging market investing, they may want to look at owning these nation’s bonds. Offering both growth and income potential, emerging market debt could be one of the best plays for your portfolio.