In a time of turmoil, a usually exciting area turns peaceful.
By Gregg Wolper | 04-22-08 | 06:00 AM | Email Article

Prominent banks and brokerage houses announce multi-billion-dollar losses. Major stock markets around the world sink and then rise with alarming speed. Fears of recession are frightening ordinary people and political leaders alike. In this tumultuous environment, an unlikely oasis of calm has appeared: emerging-markets bond funds.

Gregg Wolper, Ph.D., is a senior manager research analyst for Morningstar.

It isn't often that anything from emerging markets can be considered dull. It's particularly surprising in a time of turmoil. But a look at fund-category returns over the past year shows the emerging-markets bond group sitting quietly in the boring middle.

Not Too Hot, Not Too Cold
True, fixed-income securities from emerging markets tend not to endure the wild returns of the region's stocks. However, by bond-fund standards, the emerging-markets bond category has traditionally been a roller-coaster. In the past 10 calendar years, it has posted gains or losses of more than 20% three times; 2007 was the first year since 1994 that the category didn't post a gain or loss in double digits. (It rose 5.4%.) With most of those years providing solid gains, this category's average return for the trailing 10-year period trounces that of any other fixed-income category.

With that background, one might have expected fireworks as stock and bond markets experienced exceptional volatility owing--originally, at least--to the subprime-mortgage crisis, which started making news around this time last year. However, for the 12-month period through April 17, 2008, the emerging-markets bond category has a gain of 3.65%, which lands right around the middle of the 13 taxable fixed-income categories. And it stands far away from the levels at the extremes of the charts: Three categories have posted gains greater than 10%, and three are in negative territory.

Several factors account for this resilient, middle-of-the-road showing by a group of funds normally associated with extreme behavior. It hasn't suffered the depths of losses of certain other groups, such as the bank-loan and ultrashort-bond groups, because emerging-markets bond issuers had little or no exposure or connection to the subprime-mortgage crisis and the related fallout. And even the more indirect effects that could have had an impact, such as the concern that the broadening economic slowdown in the United States could spread, were muted by the fact that the key issuers of emerging-markets bonds are countries benefiting from skyrocketing oil prices: Brazil, Mexico, and Russia.

On the flip side, there are several reasons emerging-markets bonds didn't perform nearly as well as the best bond categories over the past 12 months--those three with the double-digit gains. The world-bond category benefited from huge currency gains versus the U.S. dollar, as well as interest-rate declines. Neither factor has a substantial effect on emerging-markets bonds. For one thing, they tend to trade more on country and corporate credit factors than on interest rates--at least compared with government and high-quality corporate bonds from developed markets. In addition, while the local-currency emerging-markets bond arena is growing in importance, the vast majority of bonds in these funds are dollar-denominated, so they received no bounce from currency movements.

As for another top-performing bond group, the long-government category, that benefited from the sharp interest-rate cuts in the U.S. and the movement of some investors away from mortgage-related securities toward safer bonds. Finally, the best-performing group was inflation-protected bonds--which is a separate story, relating to worries that the U.S. interest-rate cuts mentioned above could fuel inflation.

Bonds and Stocks: Two DifferentWorlds
Meanwhile, it's also noteworthy how sharply this category's performance contrasts with that of the emerging-markets stock group. That difference shows up in two ways. In the one-year numbers, the stock group looks great: Emerging-markets stocks stayed strong almost until the end of 2007, so the category still shows a huge 18.8% gain for the 12 months. But when the worst of the turmoil hit in 2008's first quarter that category sank, while emerging-markets bonds remained resilient: The emerging-markets stock group has lost 11.3% in the first quarter, while emerging-markets bonds are almost exactly flat.

A look under the surface reveals that these wide variances in returns aren't that surprising. One explanation is the vast difference in the country composition of the emerging-markets bond universe versus that of emerging-markets stocks. Those emerging markets whose stocks have been hit hardest this year, China and India, feature prominently in many emerging-markets stock portfolios--but they play little or no role at all in bond-fund portfolios, Conversely, oil-rich Russia and Mexico are significantly more prominent on the bond side than in equity funds. (Brazil's securities play a big role on both sides.)

Looking to the Future
The performance of emerging-markets bond funds over the past year indicates that they won't necessarily collapse when worried investors ostensibly are fleeing to quality. That's important to know.

On the other hand, it would be premature to assume that moderation is the new watchword here. Under different circumstances, broad disturbances in the markets could indeed have a substantial impact on emerging-markets bonds. In fact, some emerging-markets bonds, such as those from Argentina, have suffered deep losses over the past year. In short, while the category's recent behavior is no fluke, this arena remains suitable only for those who can accept wide swings in performance, have a long time horizon, and can understand that the regular double-digit annual gains of the recent past are by no means assured in the future.

 

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Gregg Wolper does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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