Don't Be Scared of Emerging-Markets Bonds

Have we got a deal for you! How about an investment that’s less volatile than the U.S. stock market, has returned an annualized 12% over the past ten years and is fairly cheap to own? Now, when you hear what it is, you may react viscerally and say, No way -- kind of like when you first tried stewed spinach, even though you knew it was good for you. So brace yourself.

The investment is one that owns debt of developing countries. That means government bonds from such places as Russia, Turkey, Indonesia and Mexico. As a class of investments, emerging-markets-debt funds have had a great run over the past dozen years, as many developing nations have improved their fiscal situations and instituted the rule of law in economic matters.

The specific fund I’m advocating is Fidelity New Markets Income (symbol FNMIX), managed by John Carlson. There are other good funds in this category, including some with better long-term records. But New Markets Income’s relatively low volatility, combined with its strong return, absence of a sales charge and relatively low annual expense ratio (0.95%), put the fund at the top of my list.

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Carlson acknowledges that many bond investors are apprehensive about putting money into a fund such as his but suggests that their fears may be misplaced. Such concerns were “well justified when I got into this 20 years ago,” he says. But the lack of fiscal discipline and financial regulation that used to mark those countries is now more of a problem in the U.S., Japan and Western Europe, he says.

The emerging nations whose bonds make up the bulk of the Fidelity fund have developed independent central banks and strong fiscal policies. They have experienced a “rapid improvement” in their credit standing, in part driven by the countries’ need to raise money at reasonable costs through government bonds. About 60% of the fund’s holdings are “investment grade” -- that is, rated triple-B or higher. Plus, virtually all of New Markets Income’s assets are in dollar-denominated bonds. That means currency risk is not an issue (U.S.-based investors are hurt if they have money in bonds denominated in, say, rubles and the ruble weakens against the dollar).

Carlson’s favorite country among those that are on the cusp of being moved up to investment-grade status is Indonesia. He says that most U.S. investors dismiss Indonesia as an “Islamic country somewhere out in the Pacific.” But, he says, the country is democratic, has relatively little debt and meets all of its energy needs through domestic production. It’s a tourist destination (think Bali) and has a solid manufacturing base as well. While international investment darling Brazil is the number-one country represented in New Markets Income, with 9% of assets, Indonesia bonds rank fifth, at 6%.

The fund’s volatility is relatively low. Over the past ten years, it was one-third less volatile than Standard & Poor’s 500-stock index. Of course, that is in part because New Markets Income is a bond fund, and generally, bonds are less volatile than stocks. “The dampening effect of emerging-markets bonds versus emerging-markets stocks is you’re getting paid that coupon” from the bonds, says Carlson. And having a high portion of the fund’s assets in investment-grade bonds also helps. Ironically, some investors shy away from emerging-markets bonds but embrace emerging-markets stocks, even though the returns of the bonds have rivaled those of stocks and have done so with much less volatility.

By sticking mainly to government debt, Carlson avoids corporate IOUs, which tend to be more volatile. And he doesn’t make big bets on the direction of interest rates in any of the countries where he invests. That can be a recipe for disaster if you make the wrong call.

The two top emerging-markets-debt funds over the past ten years come from GMO, both with astounding returns just shy of 15% a year. However, the funds’ managers invest in much riskier bonds and engage in other aggressive strategies. Moreover, one of the funds is closed to new investors, and the other requires a $10-million initial investment.

I’ll take Carlson’s less risky approach and bet that increasing stability in developing countries will continue to provide great returns -- no razzle-dazzle needed.