Bonds Without Borders

While stock funds have plummeted and bounced during the last five years, bond funds, for the most part, have been steady gainers. Moreover, according to mutual fund tracker Morningstar Inc., no type of bond fund has even come close to emerging markets bond funds, which have posted an annualized return of more than 14.5% during the last five years. (U.S. intermediate-term government bonds, by comparison, have returned 6.4% per year in the last five years.)

Should you put your money into these funds? Perhaps. But first you need to know what you’re buying. Emerging markets, in the language of Wall Street, include just about every place except the U.S., Canada, Japan, Western Europe, Australia, and New Zealand. Some funds hold bonds issued in the undeveloped world, either by governments or local corporations. Recently, top holdings in emerging markets bond funds included issues from Brazil, Russia, Turkey, and Mexico.

“Many of these countries have had recent credit upgrades, indicating economic and political progress,” says Arijit Dutta, a mutual fund analyst at Chicago-based Morningstar. “Those upgrades have increased bond prices. In addition, investing in these bonds may help to diversify your fixed-income holdings. However, this can be an extremely volatile category, so the risks shouldn’t be ignored.” Higher risks may lead to higher yields, which is another attractive feature about these bonds.

If you’d like to invest in emerging markets bond funds, there are several ways to do so. “I suggest them to clients who have long-term horizons and can tolerate a sharp monthly drop without having heart palpitations,” says Tracy Brown, a financial adviser with William Tell Financial Services in Latham, New York. “I might recommend that they put 5% to 10% of their bond allocation into these funds. Over time, emerging markets bond funds can add to your total returns.”

Chris Dardaman, CEO of Polstra & Dardaman, a wealth management firm in suburban Atlanta, places a small portion of his clients’ assets in emerging markets bond funds because they “have a lower correlation to the U.S. interest rate cycle.” In 1999, for example, when U.S. government bond funds lost money, emerging markets bond funds gained 27%.

“This can be a tricky asset class,” says Dardaman, “so we invest through PIMCO Diversified Income (PDVAX), a multisector fund.” The PIMCO fund invests in U.S., foreign, and as well as emerging markets bonds, adjusting its allocation to each category as market conditions change.

PIMCO Emerging Markets (PAEMX) and Fidelity New Markets Income (FNMIX) are my picks in this category,” says Dutta. “Both companies have the necessary depth in their research departments. When you invest in emerging markets, there are large differences from one country to another, and you have to be able to choose among them.” The expenses in this research-intensive category are considerably higher than those in most other bond fund categories. The Fidelity fund starts out with an advantage; its expense ratio is just under 1%.

Brown adds MFS Emerging Markets Debt (MEDAX) and Scudder Emerging Markets Income (SCEMX) to her list of favored funds in this