Emerging Market Bonds: Big Opp or Flop?

How’s this for a potential recipe for disaster: combine fixed income investing (which is receiving historic inflows) with emerging market investing (which has also seen strong inflows).

Is the fast growing but relatively new asset class of emerging market bonds leading investors into a big flop or will it ultimately prove to be an investment opportunity? Examine the charts below to prep yourself and I’ll join you after the break.

The three charts of economic indicators show that emerging markets are becoming more attractive than ever. GDP growth is strong and projected to increase. Inflation is an issue but not projected to be out of control. Perhaps more importantly to many who are bearish towards advanced markets, the level of debt in comparison to GDP for emerging markets appears spectacularly better than advanced economies going forward. (Hello Tea Party…) It seems these crucial factors point to an interesting investment opportunity — not flop — for investors: emerging market bonds.

Emerging market bonds are a small part of the investment landscape, albeit one that is quickly growing. According to Morningstar, this open end category represented just .45% (yes, less than one half of one percent) of market share as of 8–31-10. Compare this to the diversified emerging market equity category at 2.23% and you see an under owned asset class. Why such a small market share for emerging market bonds? Liquidity, perception, cost and access issues have kept many investors away from this opportunity until recently. Now this area of the market is being discovered and like previous “under the radar” investments including REITs and MLPs, emerging market bonds could be in for a nice run.

Emerging market bonds historically offer an attractive yield to investors. In addition, the increased availability of local currency denominated debt has created another potential source of return via currency appreciation. These two factors are now combining to attract US fixed income investors (and who isn’t one nowadays?) searching for a more attractive total return. The stats bear this out. From 8‐31‐2009 through 8‐31‐2010, assets in emerging market bond funds have more than doubled! No other mainstream fund category came close to that type of growth rate. Yet, as referenced before, this area seems to currently be woefully under owned by investors as the ratio of emerging market equity to debt exposure proves out. (4.9 to 1)

ETFs offer an inexpensive way to access this investment opportunity. There are currently two ETFs that focus on emerging market debt denominated in local currency: EMLC from Van Eck and ELD from WisdomTree. EMLC tracks an index, has an expense ratio of 49bps and sports a 5.2% 30 day SEC yield. Separately, ELD is actively managed, charges 55bps and lists a 4.08% 30 day SEC yield. (Numbers are as of September 29, 2010)

Whether you are a fixed income investor looking for growth or a tactical allocator searching for under owned assets, it appears emerging market bonds are poised for a continued breakout based off economic data, debt ratios and the ramp up of asset class ownership. While these bonds will experience the normal volatility associated with emerging markets, this asset class is one of the next big opportunities for long term investors.