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.

Related Articles
  1. Mutual Funds & ETFs

    The Risks Of Investing In Emerging Markets

    In a volatile market, domestic investing can be risky. Many investors choose to look overseas for diversification - but that strategy comes with its own unique threats.
  2. Bonds & Fixed Income

    Junk Bonds: Everything You Need To Know

    Don't be fooled by the name - junk bonds may be for you if you know how to analyze them.
  3. Bonds & Fixed Income

    Risks To Consider Before Investing In Bonds

    Make sure you understand the risks associated with bonds before making an investment decision.
  4. Fundamental Analysis

    An Evaluation Of Emerging Markets

    Get the full story on this asset class before you write it off as too risky.
  5. Mutual Funds & ETFs

    Should You Invest In Emerging Markets?

    Emerging markets are risky, but the rewards they can create make them a worthy addition to any portfolio.
  6. Fundamental Analysis

    Equity Valuation In Emerging Markets

    As nations like China, India and others continue to grow, valuing companies from these nations will be important for your portfolio.
  7. Bonds & Fixed Income

    5 Reasons To Trade Bonds

    Investors can find great financial opportunities in the bonds markets.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI Hong Kong

    Learn about the iShares MSCI Hong Kong fund, which invests in various equities of companies listed on the Hong Kong Stock Exchange.
  9. Mutual Funds & ETFs

    ETF Analysis: Vanguard Small-Cap Growth

    Take a close look at the Vanguard Small-Cap Growth ETF, which focuses on domestic small-cap equities with a fundamental growth strategy.
  10. Mutual Funds & ETFs

    ETF Analysis: First Trust Dorsey Wright Focus 5

    Take a closer look at the First Trust Dorsey Wright Focus 5 ETF, a unique and innovative fund of funds based on momentum and relative strength.
  1. Yield To Maturity (YTM)

    The total return anticipated on a bond if the bond is held until ...
  2. Equity

    The value of an asset less the value of all liabilities on that ...
  3. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  4. Security

    A financial instrument that represents an ownership position ...
  5. Brazil, Russia, India And China ...

    An acronym for the economies of Brazil, Russia, India and China ...
  6. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  1. What are the maximum Social Security disability benefits?

    The maximum Social Security disability benefit amount for a single eligible person in 2015 is $1,165 per month, but you can ... Read Full Answer >>
  2. What is the relationship between the current yield and risk?

    The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>
  3. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  6. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!