Investor Winterizing 2011

A Taste of Emerging Market Bond and Currency Funds

Abby Schultz,|Special to

Most retail investors have been exposed to emerging market stocks, even if only in broad international equity funds, but many are novices when it comes to investing in bondsand currencies.

Given the debt and growth problems plaguing the U.S. and eurozone, and the resulting tumult across world stock markets, it might be a good time to look at these asset classes, say analysts.

“What's happened is now not only an interest-rate play but a currency play,” Mark Mobius, executive chairman of Templeton Emerging Markets Group, told CNBC. “You've seen these currencies in emerging markets strengthen over the last five years.”

And long term, emerging markets should return to fundamentals—meaning continued growth—which will benefit bonds and currencies.

“Eventually emerging market currencies and the [Chinese] renminbi [or yuan] will be coming to the forefront,” says Ivan Leung, chief investment strategist for Asia at J.P. Morgan Private Bank. “And local, emerging fixed-income markets offer real yields. Sovereign credit ratings and fiscal fundamentals are trending upwards,” Leung adds.

In the last two years, another phenomenon has been at play: Retail and institutional investors in search of yield are finding it in long-duration bonds in emerging markets denominated in local currencies, according to research compiled by UBS.

“This is something we’ve never seen before in the emerging world,” Jonathan Anderson, economist at UBS, told clients in a Sept. 15 research report.

Gaining Entry

One way retail investors gain access to these bonds is through a handful of specialized exchange-traded fundsthat have popped up in recent years, according to Morningstar.

These funds include SPDR Barclays Capital Emerging Markets Local Bond , WisdomTree Emerging Markets Local Debt,andiShares JPMorgan USD Emerging Markets Bond.

One reason these bonds may continue to do well is that the global growth slowdown is taming inflation in hot emerging economies, leading central banks to curb interest rate hikes, says Leung at JPMorgan.

“If you are right thinking a central bank is close to finished with raising interest rates, it’s a great time to look at buying bonds,” he says.

Ted Wright, director of portfolio management at Genworth Financial Asset Management, has been investing in local currency bonds for his retail clients “to access countries that we think have higher growth potential than the U.S.”

Specifically, Genworth seeks out managers who look for opportunities in economies that are growing faster than that of the U.S., and have strong reserves backing their currencies, which allows for currencies to appreciate, Wright says. “Many of those economies are tied to the Chinese currency.”

Brian Gendreau, market strategist at Cetera Financial Group, agrees foreign bonds may provide opportunities now.

“PIMCO has for some time been arguing that it makes sense in this environment to avoid bonds of developed countries with high debt loads and paralyzed policy-making bodies in favor of bonds of countries not in that situation,” Gendreau says. “Bonds of Australia, Canada, Switzerland, and many of the emerging markets come to mind in this regard.”

Being Selective

But, Gendreau notes, emerging market local-currency bonds haven’t performed well lately.

UBS also cautions that flows into emerging market local currency bonds have been so robust lately that ironically, the trend could lead to trouble.

“This is now the one consensus overweight in the (emerging market) world, and clearly the one crowded foreign trade,” Anderson writes.

Also, investors need to remember all emerging markets aren’t alike, and that’s as important for bond and currency investors to consider as well as equity investors. There’s a vast difference between China and India on the one hand, and smaller countries, such as Estonia or Chile on the other.

Anderson went back to 2008 in another report to look at how emerging markets weathered the global financial crisis. The two lessons from that period: size and global financial exposure matter.

In other words,  the countries that fared best were larger, including China, Indonesia, and India, and less exposed to global financial markets, which were collapsing. Despite having large domestic economies, Russia and Brazil were widely exposed to foreign markets and as a result suffered, Anderson notes.

Today, most emerging economies have a lower-export-to-gross domestic product ratio than they did in 2008, so their economies aren’t as vulnerable to a slowdown in exports and “virtually no countries,” UBS says, have high or rising current account deficits, with the exception of Turkey.

Also, few countries have large foreign financial market exposures, UBS says.

The danger remains with small, open economies, however.

“If global growth comes down hard, the Thailands, Taiwans, Czech and Slovak Republics, and even the Mexicos of the world will inevitably come down with it,” Anderson writes.