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Tickers in this Article: EWZ, BWX, PCY, EMB, EMLC, ELD, BIK, EEM
Sovereign debt has come to the forefront as investors have questioned the asset types presumed safe. Recent problems with the European Union with regards to Greek and Spanish debt and Dubai's oil-filled borrowing binge have had investors in a tizzy. These recent debt concerns have many investors even feeling apprehension about the fate of more developed nations, including the United States.

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China, the largest holder of U.S. Treasury bonds, sold nearly $24 billion worth of those bonds in July. This was the second straight month that the nation reduced its treasury holdings. Low yields and high debt-to-GDP ratios have many investors scratching their heads over where to look for income. The answer may come from investment destinations normally reserved for capital gains.

Looking Towards Emerging Markets

While an investor might add Brazil, through the iShares MSCI Brazil Index (NYSE:EWZ) as a capital gain component to acquire access to the nation's growing economy, equal as interesting are its bonds. Analysts for the Bank for International Settlements calculate the size of the global bond market to be $82.2 trillion in 2009, while the size of the world equity marketplace is estimated to be only about $36 trillion. The growth of the debt market has come from a number of sources, including the creation of new bond types and an expansion in the number of countries able to tap these debt markets.

The appeal of playing emerging markets through their debt securities is that unlike the U.S. or Japan, these nations often have lower debt-to-GDP ratios. For example, Brazil has an approximate 60% debt-to-GDP and for Malaysia it's around 35%.

These manageable ratios stem from strong balance sheets, fiscal responsibility, strong commodity resources and overall superior long-term prospects. The IMF reports that emerging markets had account surpluses of $355 billion in 2009. These surpluses are forecasted to grow to almost $550 billion in 2010. Citizens in emerging markets are also savers. Developing markets had gross national savings of 33% of GDP in 2009.

In addition, these bonds often yield in the 5-8% range versus less than 1% for the developed market SPDR Barclays Capital International Treasury Bond (NYSE:BWX). While there is risk, investors are generally getting higher yields with stronger nations backing the bonds.

Difficult to Access

While buying individual corporate or treasury bonds is quite easy, adding individual emerging market sovereigns is almost impossible. Many domestic brokerage firms require that investors purchase $100,000 worth of one bond. Demand from the retail side is low, causing the bid/ask spread to be too wide for small orders. However, with the proliferation of exchange-traded funds, anybody with an account can access these securities.

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 a reliable protection if an issuing country began to falter; the dollar would hold it up.

There are two emerging market debt funds that hold U.S. denominated bonds, the PowerShares Emerging Markets Sovereign Debt (NYSE:PCY) and the iShares JPMorgan USD Emerging Markets Bond (NYSE:EMB). The two funds hold nearly $2 billion and $790 million in assets, respectively. The EMB holds 65 different bonds and the PCY, 56. Both give investors access to bonds from nations such as Indonesia, Peru, Poland and Brazil. The PowerShares fund yields just under a full percentage point more than the iShares ETF, at 5.55% versus 4.77%.

One of the benefits of investing abroad is that currency fluctuations can work with or against you. Many emerging market currencies have gained versus the dollar over time, juicing returns for those who hold bonds denominated in those local currencies.

Two new exchange-traded funds allow investors to bet that the greenback will continue its decline against local currencies. The Market Vectors Emerging Markets Local Currency Bond (Nasdaq:EMLC) and the actively managed WisdomTree Emerging Markets Local Debt (NYSE:ELD) will also provide capital gains and generous 6-7% dividends to investors in the sector. (These coupon bonds are transferable, negotiable and anonymous - so why aren't they sold in the U.S.? For more information, see Bearer Bonds: From Popular To Prohibited.)

The Bottom Line

Investors are rethinking the safety of developed market sovereign debt after the recent problems in the eurozone and Middle East. Even the safety of U.S. treasuries is coming under scrutiny. Income investors may want to look to emerging markets to find good yields. Many of these bonds are investment grade and are backed by nations with budget surpluses and low debt-to-GDP ratios. The proceeding ETFs are some of the easiest ways to access the asset type.

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