By JACK HOUGH
Emerging-market bonds might be that rare investment that holds appeal for both the aggressive and the timid.
The aggressive investor will like the 6.5% yield on the JP Morgan Emerging Market Bond index. That's triple what investors get from 10-year bonds issued by the United States, Germany or the United Kingdom and a couple of percentage points more than high-quality U.S. corporate bonds pay.
The timid will take comfort in the rapidly improving creditworthiness of emerging markets at a time when developed countries are struggling to control their finances.
Not all emerging markets are flush, of course, but as a group they have debt equal to around one-third of their gross domestic product, half that of the U.S., according to Joyce Chang, head of global credit research at JP Morgan. The average emerging market is running a budget deficit of around 2% of GDP this year, versus more than 11% for the U.S.
Countries like Brazil, Mexico, Taiwan and Malaysia are are owed more by foreign governments than they owe to them. Of the world's $10.1 trillion in foreign exchange reserves, $8 trillion is held by emerging-market governments, according to Ms. Chang.
Credit downgrades for the the U.S., Japan, Spain and Ireland have grabbed headlines in recent years. But less noticed this year were upgrades in countries like the Philippines, Panama and Bulgaria. Standard & Poor's now rates Estonia and the Czech Republic at the same level as Japan. The investment grade portion of the JP Morgan Emerging Markets Bond index has jumped from 2% in 1993 to 58% today.
Seasoned investors might recall a string of late-1990s currency collapses in emerging markets like Thailand, Russia and Brazil. Those crises forced policy makers to abandon fixed interest rates, fight inflation, increase savings and dramatically reduce debt, says Ms. Chang. Rapid growth has helped, too. Emerging-market GDP, already close to half of world GDP, is growing at 5% a year, versus less than 1% for developed market GDP.
It's premature to call emerging-market bonds a safe haven, says Sam Finkelstein, a portfolio manager with Goldman Sachs Asset Management. Many have weaker institutions than the U.S. and greater currency volatility, but the fundamentals are good and the trend is improving.
The universe of bonds is also expanding. Emerging-market corporations have issued more bonds than governments for six years running, he says. Some of these companies carry unique risks, like excessive government control, but the expanding menu is allowing bond-fund managers to shop for higher corporate yields while diversifying currency exposure.
"It's not an either-or choice between developed-market bonds and emerging-market ones," says Matthew Ryan, who oversees three bond funds for MFS Investment Management. "Most investors should have exposure to both."
During the 2008 financial crisis, emerging-market bonds were "last in, first out," says Mr. Ryan. "They were the last to be affected and the first to recover," he says. "I think that shows strength."
Most investors looking to buy emerging-market bonds will want to use mutual funds in order to get proper diversification. There are two main choices to be made. The first is whether to use a low-cost passive fund that tracks an index or a higher-cost active fund with a manager who picks bonds.
The second is which types of bonds to favor. In addition to the choice between sovereign and corporate bonds, there are dollar-denominated bonds and local-currency bonds. The latter are subject to currency swings, which is a minus for investors who are bullish on the dollar but a plus for those who believe emerging-market currencies will appreciate versus the dollar.
The iShares JP Morgan USD Emerging Markets Bond Fund (EMB),
Some actively managed funds might be worth their extra cost, because bond indexes tend to weight issuers according to the amount of debt outstanding rather than the investment merits of countries or companies.
The TCW Emerging Markets Income fund has much larger corporate bond exposure than peers. That has helped it return 12.6% a year on average over the past decade, beating the JP Morgan index by more than two percentage points a year. But it also caused the fund to lag behind the index by more than nine percentage points during the tumultuous third quarter as investors fled for the relative safety of government bonds. The fund costs $92 a year per $10,000 invested.
The MFS Emerging Markets Debt fund, which Mr. Ryan manages, has a 14% weighting in corporate bonds. Its "class A" shares are pricey, with a maximum up-front sales charge of 4.75% and yearly expenses of $119 per $10,000 invested. But over the 10 years through September they beat the JP Morgan index by 1.4 percentage points a year after expenses.
Finally, the Pimco Emerging Markets Bond fund is a good fit for Brazil fans, with its 39% exposure to that country. Its A shares cost a maximum of 3.75% up front plus $125 a year per $10,000 invested. Over the 10 years through September, they beat the JP Morgan index by nearly a percentage point per year after expenses.
Going forward, investors shouldn't expect these funds to produce the double-digit yearly total returns of the past decade. But although assets linked to emerging-market-bond indexes have doubled in four years, investor exposure to these bonds is still small, says Lupin Rahman, a portfolio manager for Pimco. "As investors become more savvy about emerging markets, there's substantial opportunity left for these bonds to gain value relative to developed world bonds."