Emerging markets bond funds topped all fixed-income categories with a 10-year annualized return of 8.3% through last month, nearly double the 4.4% return of domestic long-term bond funds, according to Morningstar.
And financial advisors think that strong showing will continue.
“The three primary factors for this outperformance in the past decade are still in place,” says Michael Francis, president and chief investment officer of Francis Investment Counsel in Brookefield, Wis. “We’re maintaining 5% to 10% allocations to emerging markets bonds.”
The first factor that Francis mentions is the relatively high yield of emerging markets bonds.
“The Barclays Capital Aggregate Bond Index currently yields 2.3%,” he says. “The J.P. Morgan Emerging Markets Bond Index yields 5.4%. That type of relative yield advantage probably will continue,” Francis says.
Beyond higher yields, emerging markets bonds also attract investors because the home nations are reporting faster economic growth than the United States and other developed countries.
“The third factor is related,” Francis says. “As their economies grow, the credit quality of emerging nations’ bonds improves.”
The higher credit quality makes the bonds more secure, attracting more buyers, and the increased demand strengthens the bonds’ prices.
“Nothing on the radar suggests these factors will change in the next 10 years,” Francis says. “Some emerging markets may have problems, but in the aggregate we expect to see relatively fast economic growth and improved creditworthiness.”
Emerging markets bonds are volatile so they aren’t for everyone, Francis says.
Nevertheless, most of his clients hold actively managed funds in this category.
“We prefer funds that mainly hold government issues—sovereign debt—because those bonds tend to be more predictable than corporate bonds from emerging markets,” Francis says.
Fund management experience and low costs also are important.
Expense ratios for these funds should be less than 100 basis points or 1%, Francis says.
Advisors can also use other tactics for exposure to emerging-markets bonds.
“We do not invest directly in emerging markets bonds because we use PIMCO Diversified Income Fund, which has a moving allocation to this asset class,” says Cheryl Holland, president of Abacus Planning Group in Columbia, S.C.
“This fund allocates between U.S. corporate, high-yield, and emerging-markets debt,” she says. “We think the manager has a better skill set than we do to allocate among these higher-risk fixed-income opportunities.”
Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.