Is emerging markets debt a good investment?

"The impact of currency debasement or the impact of stronger currencies on emerging markets is extreme. A shift in the currency could annihilate an emerging market quickly. It puts investors under a significant amount of risk," says Jeff Sica, president and chief investment officer of Sica Wealth Management in Morristown, N.J.

For example, "If you have the rand in South Africa appreciating against the dollar, anything denominated out of South Africa would have the potential to appreciate because of appreciation of the rand," he says. That can be a good thing, but if the local currency goes the other way, weakening against a strengthening dollar, investors in the U.S. can lose out.

Mutual fund investors needn't become world currency experts, but it's something to be aware of when picking funds as well as understanding possible sources of volatility.

The exchange rate is the obvious source of volatility for local currency bonds, but dollar denominated EM bonds are not without their own risks.

"Changes in interest rates or policy rates in the U.S. obviously have a very immediate effect on dollar-denominated securities," says Antin. "Dollar securities are going to respond much more to 50 basis point rallies in 10-year U.S. Treasuries than securities denominated in Brazilian real or Turkish lira or South African rand or whatever local market."

Emerging markets debt good for growth and yield

Even if you view the bond portion of a portfolio as a nest of stability and safety, there may be room for emerging markets bonds that don't quite meet those criteria.

"I think emerging markets debt has a place in a portfolio, but it is a small percentage, not 20 (percent) or 30 percent. It will be pretty volatile. However ... when you add a volatile instrument into a portfolio with several other things, usually it decreases the volatility of the portfolio overall," says Donald Cummings, founder and portfolio manager at Blue Haven Capital LLC in Geneva, Ill.

Besides, it's hard to pan emerging markets as being too risky for investors when developed countries are stumbling. Last year, ratings agency Moody's knocked the U.S. credit rating by a notch, and most recently, Italy was downgraded two notches by Moody's.

Economic fundamentals in developed countries are also floundering. Growth in the U.S. has improved since the financial crisis, but has lapsed into sluggish territory in 2012.

Conversely, some developing countries still have plenty of room to grow and are steaming ahead. For instance, China's growth may be weak relative to its history, but relative to growth in the U.S., Europe and Japan, its strength is something to marvel.

Government debt levels in developed countries are nearly 100 percent of gross domestic product. "By contrast, for EM public-sector debt, the needle barely moved over the past five years," says Antin. "It went from 33 percent of GDP to about 35 percent of GDP, so a 2 percent increase versus a 20 percent increase."

While economic fundamentals are decidedly healthier in emerging markets, investors are compensated for the added risks inherent in emerging markets.

And, almost counterintuitively, EM corporate debt generally has higher ratings than EM sovereign debt -- plus better returns.

"The dollar sovereign index is currently 350 basis points over U.S. Treasuries," Antin says. "The corporate index in dollars, which is rated slightly higher than the sovereign index in dollars, was 395 -- so an extra 45 basis points over the sovereign dollar index, and you're getting one rating notch higher."

The average yield in the local currency index is about 500 basis points more than Treasuries.

For today's yield-starved fixed-income buyers, the high returns in emerging markets debt can be tempting. It may make sense for many investors to diversify into emerging markets debt. But before jumping in, investors should understand the risks and know what they're buying.


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