Emerging market bonds, or fixed income debt that is issued by countries with developing economies as well as by corporations within those nations, have gained traction in investor portfolios in recent years. This has been attributed to emerging market bonds' rising credit quality and conceivably higher yields relative to domestic corporate and Treasury bonds. As is often the case in the investment world, however, higher returns often come with an increased level of risk and emerging market issues do tend to carry higher risks than those associated with Treasuries and domestic corporate bonds. In this article, we'll take a look at emerging market bonds and weigh the potential risks and rewards versus other fixed income asset classes. (Learn more on building a portfolio using these asset classes in Asset Allocation With Fixed Income.)

The Evolution of Emerging Market Bonds

Prior to the last two decades of the twentieth century, emerging market bonds were intermittently issued by developing countries primarily in U.S. dollar denominations.

In the 1980s, however, Treasury Secretary Nicholas Brady began a program to help global economies restructure their debt by issuing bonds. Many countries in Latin America issued these Brady bonds in the late 1980s and early 1990s, marking an upswing in the issuance of emerging market debt.

As the market for emerging debt began to grow and as additional foreign markets began to mature, growing countries began to issue bonds more frequently, both in U.S. dollar denominations and each government's currency. These have now widely become known as "emerging local market bonds". In addition to these issuances, foreign corporations began selling debt, giving a boost to the global corporate credit market. (For background reading, see Spice Up Your Portfolio With International Bonds.)

Macroeconomic Sophistication Paves the Way
The expansion of the types of bonds issued by countries with emerging economies also importantly coincided with a growing sophistication of the macroeconomic policies of these developing nations, such as the implementation of cohesive fiscal and monetary policies, which gave foreign investors confidence in these countries' long-term stability. As investors began to act upon the increased reliability of the economies of developing nations and the growing diversity of the bond issuances, emerging market bonds rose as a major fixed-income asset class.

Bonds are issued from developing nations and corporations based in countries, such as Asia, Latin America, Eastern Europe, Africa and the Middle East. The types of fixed income opportunities, in addition to Brady bonds and local market bonds, include eurobonds and Yankee bonds. Emerging market debt is also offered in a wide array of derivatives as well as short and long duration bonds. (Bonds with higher duration carry more risk, making this measure an important one for investors to calculate. Learn more in Advanced Bond Concepts: Duration.)

The Potential Risks of Investing in Emerging Market Bonds
The risks of investing in emerging market bonds include the standard risks that accompany all debt issues, such as the variables of the issuer's economic or financial performance and the ability of the issuer to meet payment obligations. These risks are heightened, however, due to the potential political and economic volatility of developing nations. Although emerging countries, overall, have taken great strides in limiting country risks, it is undeniable that the chance of socioeconomic instability is more considerable in these nations than in developed countries, particularly the U.S. When assessing the risks associated with each emerging nation, investment analysts often refer to that country's sovereign risk.

Emerging markets also pose other cross-border risks, including exchange rate fluctuations and currency devaluations. If a bond is issued in local currency, the rate of the dollar versus that currency can positively or negatively affect your yield. When that local currency is strong compared to the dollar, your returns will be positively impacted, while a weak local currency adversely affects the exchange rate and negatively impacts the yield. If you do not want to partake in currency risk, however, it is possible to just invest in bonds that are dollar-denominated, or issued only in U.S. dollars. (Read more about investment risk in Measuring and Managing Investment Risk.)

Following Developing Markets
There are a number of indexes that follow the performance of emerging market bonds, most notably the J.P. Morgan Emerging Markets Bond Index Global (EMBI Global) and the J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI). The EMBI Global covers debt issued from over 25 countries including China, Russia, South Africa, Brazil and Poland, while the CEMBI follows corporate issues for approximately 80 bonds from more than 50 corporations in 15 nations.

Emerging market debt risk is assessed by rating agencies that measure each developing nation's ability to meet its debt obligations. Standard & Poor's and Moody's ratings tend to be the most widely followed ratings agencies. Countries that have a rating of 'BBB' (or 'Baa3') or higher are generally considered investment grade, meaning it is safe to assume the country will be able to repay its debts. However, lower ratings are indicative of speculative grade investments, suggesting that the risk is relatively higher and that the nation may not be able to meet debt obligations. (To learn more, read What are the risks of investing in a bond?)

One investment instrument that can protect bondholders against the risk that developing sovereign nations or foreign companies will be unable to repay their debts are credit default swaps (CDS). CDSs have the ability to protect investors by guaranteeing the face value of the debt in exchange for the underlying securities, or their equivalent in cash, if the nation or the corporation fails to honor the debt. (To learn more, read Credit Default Swaps: An Introduction.)

However, while credit default swaps protect investors from potential loss, a sharp increase in the credit default swaps market for a particular developing nation can often indicate a growing concern that the country (or corporations within that nation) may not be able to honor its debt. So, both lower agency ratings and a basis point rise in a nation's credit default swaps are considered red flags with regard to a particular emerging market and its ability to repay debt to investors.

Why Invest in Emerging Market Bonds?
Despite these risks, emerging market bonds offer numerous potential rewards. Perhaps most significantly, they provide portfolio diversity, because their returns are not closely correlated to traditional asset classes. In addition, many investors who are looking to offset the currency risk present in the rest of their portfolios choose to invest in emerging market bonds issued in local currencies as a valuable tool in hedging this risk.

Investors often track the yield of U.S. Treasuries versus emerging market bonds and look for a widening of the spread, or extra yield, that emerging market bonds can offer at any given time. The higher the basis point spread of this yield is (i.e. the higher the emerging market yield is relative to Treasuries) the more attractive emerging market bonds are relative to Treasuries as an investment vehicle and the more willing investors are to take on the other inherent risks of emerging market bonds. (If you want government securities, go straight to the source. We'll show you how in Buy Treasuries Directly From The Fed.)

One factor that drives the potential for increased yields for emerging market bonds is that developing countries have a tendency to grow rapidly, which can often enhance returns. For this reason, among others, yield returns of emerging debt have historically been higher than those of U.S. Treasuries.

How to Invest in Emerging Markets
If you decide that the potential rewards offset the potential risks of investing in emerging market bonds, there are numerous options, although there are some limitations. When investing in emerging markets, in many cases it is not possible, or highly improbable, for an individual investor to invest directly in a developing country's bonds or debt issued by foreign corporations. Most U.S.-based mutual fund companies, however, have a variety of emerging market fixed income funds to choose from. (To learn more, read Bond Funds Boost Income, Reduce Risk.)

These funds have options of bond issuances from developing countries and corporations denominated in U.S. dollars and/or local currencies. Some funds invest in a diversified mix of emerging market bonds from all over the world while some focus on regions, such as Asia, Eastern Europe or Latin America. Additionally, some funds focus exclusively on government issues or corporate bonds, while some have a diversified combination.

Emerging markets have now become a fixture in the global fixed income investment universe. As developing countries continue to grow, the investment opportunities will only expand. While there are inherent risks associated with investing in developing economies, sufficient rewards may be available for discerning investors who take the time to educate themselves about emerging market bonds. (For related reading, see Investing in Emerging Market Debt.)