To the surprise of many, emerging-market debt has performed well.

In the universe of emerging-market finance, spectacular international flameouts are common. The Asian contagion spooked the financial markets in 1997, while Russia, getting itself entangled with Long-Term Capital Management, tripped up a year later. Argentina registered the biggest sovereign default in history in 2001, and around the same time Brazil and Ecuador experienced their own financial tantrums. When you add the dramatic slowdown in the global economy in recent years to this international dishonor roll, observes Mohamed A. El-Erian, a Pimco managing director, "You couldn't imagine a worst set of circumstances."

The gloom, however, shrouded a curious trend that very few people initially noticed. Despite bleak dispatches from distant time zones, emerging-market debt was making money for its investors. In fact, tons of it. Take a look at Morningstar's top 25 bond funds for the last five years and you'll notice that each one is devoted to emerging-market debt. GMO Emerging Country Debt IV, the No. 1 fund during the period, generated a five-year annualized return of 26.59% through September 30. The average emerging-market bond fund, over that five-year time period, returned 19.18%. Even more impressive: During the past 13 years, emerging market debt has reigned as the world's best-performing asset class.

With stats like these trickling out, speculators have been throwing money at debt in places like South Korea, Chile, Poland and Russia. More cautious investors, hungry for yield in this miserly, low-interest-rate environment, have followed along. According to Lipper, today's emerging-market debt funds are offering an average yield of 7.05%. Meanwhile, the cash flowing into this niche fixed-income category in 2003 from pension funds, endowments and other institutional investors has hit historic highs.

Yet the vast majority of retail investors don't even know the asset class exists. "This is an undiscovered part of the financial world," observes Bill Nemerever, partner and co-head of the group that manages global bonds at Grantham, Mayo, Van Otterloo & Co. It is also an asset class, Nemerever adds, that "can scare the hell out of you." During the Russian crisis in 1998, for example, the average emerging-debt bond fund plummeted 34% in just three months. Not the sort of volatility that a retiree who cozies up with Treasuries could stomach.

For investment advisors the question remains, is emerging-market debt a legitimate asset class? Many experts suggest that it is. They feel comfortable vouching for these mercurial bonds because of fundamental changes within the countries that are issuing this debt, as well as outside economic forces. "The asset class has gradually matured in terms of creditworthiness, information accuracy and availability, market infrastructure and investor base," observes El-Erian, who heads Pimco's emerging-markets portfolio management. On the other hand, some advisors insist that the guy hoarding the Treasuries has the right idea. Play it ultrasafe with a portfolio's fixed-income side, and leave the risk-taking for equities.

Perhaps the most visible proof that emerging debt is shedding a bit of its Molotov cocktail image is the dramatic improvement of its credit quality. Five years ago, less than 10% of debt in the emerging market indexes was investment grade, but today more than 40% is. Within the next few months, El-Erian predicts, 60% of the debt will earn that distinction. These bonds gained even more respectability in October, when Moody's Investors Service announced that Russia's debt, which just five years ago was in default, was being elevated to investment grade.

Numerous reasons exist for the turnaround. First, many emerging countries have developed sounder fiscal policies, including establishing independent central banks and overseeing flexible exchange rates. Having learned from previous government crises, Asian countries as well as other emerging nations such as Russia, Poland, Mexico, Brazil and Ukraine, have built up their international reserves, which could act as shock absorbers during times of crisis. On the liability side of the ledger, nations have been shedding their debt. Every region in the emerging world can point to improved current account balances.

In looking for global opportunities, money managers primarily invest in debt issued by governments, not corporations, making sovereign bonds this asset class's prime attraction. It's a distinction that some experts use to explain why this debt has outsprinted emerging-market equities, a favored asset class that's far more likely to be found in sophisticated asset allocations. (During the past five years, according to Lipper, the average return for emerging-market equity funds has been 10.75%, which is a whopping 843 basis points behind emerging-market debt funds.) When nations experience financial troubles, they can protect their bondholders and their own hide by raising taxes, cutting spending and bumping up interest rates. In the process, many countries shift the financial burden to equities, which can get creamed.

What also attracts investors to emerging-market debt is its low correlation with other investments-at least some of the time. "In relatively good times, emerging-market bonds seem to have unique return characteristics," says Campbell R. Harvey, professor of finance at Duke University and co-editor of the Emerging Markets Review. Correlation, however, often surfaces when it's least welcome. "In times of crisis," he says, "returns are highly correlated with equity market returns."

Despite the recent interest, emerging debt remains a bit financial player. There's only about $500 billion to $750 billion worth of tradable emerging-market debt. One reason for its relative obscurity is its brief existence. The asset class was born in the late 1980s when bank loans were securitized into Brady bonds. Although Brady bonds first appeared in Mexico, within the decade they had spread across Central Europe, Latin American and Africa. Today, Brady bonds represent less than half of the emerging-debt market.

The asset class couldn't even claim its own index until JP Morgan rolled out the first of its emerging-debt indexes beginning in the early 1990s. Consequently, performance figures for this asset class can only stretch back that far. Today, the most popular index is the JP Morgan Emerging Markets Bond Index Global Diversified. The three countries most represented in this index are Mexico, 11.6%; Russia, 10.6%; and Brazil, 9.7%.

Emerging-market debt has no shortage of potential predators. Future jumps in interest rates in the United States could hurt overseas by driving borrowing costs higher. Emerging economies should be able to weather a 50-basis-point jump in interest rates in this country, but an increase in the neighborhood of 200 basis points could hurt, says Nemerever, who helps manage GMO's emerging-debt funds. Meanwhile, Americans outraged by the shrinking of domestic manufacturing jobs and the jobless recovery, are clamoring for protectionist policies. Default and political risks need to be considered too.

Experts, however, suggest that the phenomenon of contagion, which has traditionally loomed as one of the asset class's biggest threats, doesn't appear to be as menacing anymore. With contagion, a fiscal crisis in one struggling country can devastate the bonds in other, weaker nations as investors flee. That's what happened in 1997 when the Asian crisis hit. The contagion, however, didn't reappear in 2001 when Argentina floundered.

Why the difference? One explanation is that the asset class is no longer so dependent on speculative hot money. While hedge fund managers are more likely to dump emerging-market debt when things get dicey, institutional money from pension funds and elsewhere is more likely to view the investment as a long-term holding.

Some investment advisors remain unimpressed by the allure of emerging-market debt. Larry Swedroe, research director at Buckingham Asset Management in St. Louis, suggests that including emerging-market debt in a fixed-income portfolio is akin to tucking sticks of TNT inside it. "My view is that fixed income, for the vast majority of people, should be the anchor that keeps them safe when things aren't going well with equities," he says. "Fixed income for most investors should only be in AA and AAA paper, short to intermediate term."

For advisors interested in investing in emerging-market debt, Swedroe suggests putting the tax-inefficient asset in a tax-deferred account. He acknowledges, however, that there's a downside to this approach. "Because of its high volatility," he says, "there are likely to be opportunities to tax-loss harvest, but of course this can only occur in a taxable account."

For such a volatile asset class, you'd expect the spreads between emerging-market debt and ten-year Treasuries to be significant. Spreads, however, have been tightening since the Russia default in 1998, observes Kristin Ceva, who manages the Payden Emerging Markets Bond Fund. During that time, the spread widened to 1,600 basis points. By 1999, the spread had dropped to 1,400 basis points. With spreads continuing to tighten, the emerging-market debt funds have generated those impressive returns.

But there's not much room for further squeezing. With the small asset class gaining in popularity, the spread today has shrunk to around 500 basis points. Investors, consequently, shouldn't expect a continuation of jumbo-sized gains. In the near term, Nemerever predicts total returns settling in the 9% to 10% range.

The easiest way to invest in emerging debt is through mutual funds. Lipper tracks just 50 emerging-market debt funds, but that's a misleading number since it includes different funds' multiple share classes. The money managers with bragging rights to the best records are GMO and Pimco. Pimco enjoys the best three-year record, and GMO maintains the top five-year record. To get into one of GMO's institutional funds, however, you'd need at least $1 million. PIMCO has institutional as well as retail classes.

There's also a new investment option called TRAC-X Emerging Markets. It's the latest addition to the TRAC-X global suite of credit default swap indexes formed by Morgan Stanley and JP Morgan earlier in 2003. TRAC-X EM is a tradable portfolio of five-year credit default swaps that represent a diversified liquid pool of emerging-market sovereign credits. The credits come from a subset of the countries comprising the JP Morgan Emerging Markets Bond Index Global Diversified. The minimum investment requirement is $100,000.

Although no one knows what will happen next in the world of emerging-market debt, Harvey is optimistic. "I think the force of globalization, the force of slow and steady growth rather than a kind of saw-tooth pattern in the U.S., and the gradual reduction of overall geopolitical risk all work favorably for emerging-markets bonds and equities." Consequently, he adds, "It's difficult to make the case that you should not be in emerging-market bonds."