As the developed world leveraged itself to the eyeballs over the years leading up to the financial crisis, emerging market countries were quietly applying lessons from their past economic crises, putting their financial houses in order. Still mindful of the debt crises of the past, many have built thriving economies, strong currencies and expanding middle-class consumer bases.
That discipline has led to a hot streak, not only in the stocks of these countries, but in their bonds. The J.P. Morgan Emerging Markets Bond Index returned nearly 12% in 2010, comparable with a lot of other strong fund categories.

"As we look at the 2010 performance of emerging market debt, it almost seemed that it did not matter which sector of the market you were invested," said Luz Padilla, portfolio manager of the DoubleLine Emerging Markets Fixed Income Fund, while speaking during a Webcast on February 8. "Whether you were in external sovereign corporate debt or local currency bonds, an investor would have earned low-double-digit returns for the year."

Knowing a good thing when they see it, investors have flooded into the space, hungry for yield and richer currency appreciation: According to tracker EPFR Global, emerging market bond funds drew in a net $53.6 billion in 2010. That's five times more than the year before, when it took in a net $9.5 billion. (The previous record was $9.7 billion in 2005.)

But then in early 2011, life got in the way. Just as soon as bond investors finished their banner year in the developing world, they woke up to find something else emerging: a cascade of popular uprisings and anti-authoritarian revolutions tearing through the oil rich Arab nations. Since the beginning of 2011, pro-democracy movements have fanned across Northern Africa from Tunisia, to Egypt, to Libya and kindled demonstrations in Iran, Kuwait, Algeria, Morocco, Iraq, Bahrain and Yemen. The turmoil has caused oil prices to spike and emerging markets to swoon.

The protests may seem to have condensed spontaneously from the pages of Facebook, but they in fact occurred against a backdrop of rising food prices and unemployment. Core food inflation has been bad for people in the streets, and it might prove to be bad for local bonds, too, causing interest rates to rise and bond prices to dip.

"I don't think [the revolts] would have happened necessarily, at least in this time frame and this quickly, if we didn't have the inflation problems," says George Strickland, co-manager of the Thornburg Strategic Income Fund. "If you look at the inflation indices in emerging market economies, in many cases more than 50% of their inflation index is food prices."

Meanwhile, the amount of money that's flowed into the space has some worried that yields have slunk, which means investors are getting similar rewards as they would in developed market bonds but taking bigger risks. Those worries, as well as the worries about core inflation might likely give some developing market bond fans pause and prompt them to hit the sidelines for now to rake off their profit.

"I think we've noticed over the past month or so that there's been a tendency to perhaps book gains from the strong performance that we've seen in the sector over the past two years," says Howard Booth, director and co-head of international fixed income at MacKay Shields. However, Booth, who oversees the MainStay Global High Income Fund, also says the fundamentals in the space are still strong.

Advocates cite low debt to GDP levels in emerging market countries, and insist that rising commodity prices (for copper, oil and iron ore) should buttress many emerging economies, especially as China continues to grow. EM bond cheerleaders also cite the increasing EBITDA margins of emerging market corporates and the rising number of investment-grade credits. In 2010, several sovereigns were upgraded by one or more of the rating agencies, some of them out of junk status. The upgrades include Panama, Costa Rica, Guatemala, Turkey, Indonesia, Morocco, Uruguay, Ukraine and the Dominican Republic.

"Over the long term, we are still very positive on the asset class and that's primarily because of fundamentals continuing to be positive," says Cristina Panait, a co-manager of Payden & Rygel's Payden Emerging Markets Bond fund. "We think that story hasn't really changed. Emerging markets are much better positioned than developed markets."

Ways To Play
If you can grit your teeth and bear the news from overseas, there are many different ways to play the market, according to your temperament. The biggest debates are whether you should be in the local currencies or in U.S. dollar denominated issues. If you stay with the former, you've got a lot of volatility (and a queasy stomach). If you stay with the greenback, you risk the deflation of the U.S. dollar against these raging tiger countries and their domestic success stories.

Padilla at DoubleLine said in her Web cast that her firm is looking at emerging market corporates denominated in U.S. dollars, and she claims that local currencies are too volatile for her team. "The emerging market corporate index, which is denominated in U.S. dollars, and the local currency emerging market government bond index both delivered over 13% returns in 2010," she said, but added, "The volatility of the local currency emerging market bond index was over four times that of the emerging market corporates."

She also points out that Indonesia and Brazil have taken measures to stop their currencies from strengthening. "As a result of these measures, we believe that currency appreciation could be capped, thereby limiting the potential for total return from these investments."

Padilla said her firm is finding opportunities lower down the risk band. "Emerging market corporates are restoring their balance sheets by reducing their leverage ratios," she said. "These credits, when we compare them to their U.S. comparably dated companies, have lower leverage ratios across all rating categories. We took 200 companies and divided them into three rating categories, triple-B, double-B and single-B. And we note that the leverage for all of the rating categories is lower for emerging market corporates than for their U.S. counterparts." She says that some emerging market companies rated double B actually had less leverage than U.S. triple-B's.

While Padilla is wary of sovereign bonds, Michael Cirami, a vice president and portfolio manager with the global fixed income team at Eaton Vance, loves them. He says that right now he's looking mostly at sovereign plays in local currency rather that corporates-auguring, like other managers, that the appreciation of local paper money will outstrip the wilting lettuce known as the U.S. dollar.

"In 2011, we think really the opportunities in that space are in the local debt," says Cirami. "And here the call is really the currency valuations. When you look at the world and you see the problems that we have today and some of the imbalances out there, the correcting of these balances is one that calls in our mind for strength to emerging market currencies. And one of the best ways to play this is in the local debt."

A persistent worry about these local currencies is that global inflation will eat into that sweet currency yield. Some countries also seem determined to keep their currencies capped so that developed countries will still buy their goods cheap. Cirami thinks inflation would actually be a good thing for local currency bonds because it will force central banks to tighten up their monetary policy to keep their moneys strong.

"We think that the central banks in the emerging market space are going to want to keep the gain in credibility that they've had through fighting inflation over the last decade and not be too complacent," he says.

Among the currencies he likes are those in the Czech Republic, Poland, Israel, Kazakhstan and Serbia. He's also bullish on the currencies of Brazil and Indonesia but not as much as he is on the economies themselves. "I would say that there is a little bit of that disconnect and we're more bullish on the fundamentals of the economy than on the currency," he says.

MacKay Shields' Howard Booth, meanwhile, likes both corporates and local currency bonds within Brazil and Mexico for their higher yields and moderate volatility. "In addition, there's a couple of Asian currencies that I feel are attractive," he says. "I like the Philippines' local bond side. My preference is to be in the middle to short end of the market because a lot of emerging markets that have less idle capacity are being challenged with increasing inflationary pressures. We are watching closely to see if the central banks generally are willing and able to stay ahead of the curve."

He's also overweight in Russia and the Ukraine. Otherwise he likes Eastern Europe less, since it is not exporting commodities and it might have more exposure to Western Europe's debt woes (the Greek debt crisis sapped the vitality of emerging market bonds a bit last year). Meanwhile, Turkey is a large part of the JP Morgan Emerging Market Bond Index Global Diversified, which is Booth's benchmark, but the country has a current account problem, he says, which is going to be exacerbated by the rising oil prices since it's a large energy importer. For that reason, it's less favorable to him. "It would likely underperform if oil prices were elevated," he says.

Panait at Payden & Rygel says her fund is overweight in Latin America and Asia, and she underweights Eastern Europe, the Middle East and Africa. "Again, that's on the back of more positive fundamentals in Latin America and Asia in terms of their debt to GDP and their fiscal trends," she says. In Eastern Europe, the fund shuns countries like Hungary and Poland and overweights Russia, for its higher oil prices, and Ukraine, whose economy has stabilized and overcome political woes.

"Also, we think that relative to other countries that are rated triple-B, Russia continues to trade cheaply, so we actually have a combination there of the U.S. dollar-denominated sovereign as well as some of the quasi-sovereign names, so these are corporates that are owned by the government such as Gazprom in Russia.

"In Asia," she continues, "our primary theme is our currency trade being long in some of the Asian countries. So we're long the Philippine peso, we're long the Malaysian ringgit and the Singapore dollar."

Loomis Sayles is another company trying to help investors deal with inflation risks and a market with depressed yields. At the end of 2010, the company launched a couple of bond funds, the Multi-Asset Real Return Fund and the Absolute Strategies Fund. Though they have slightly different strategies, both have a go-anywhere mandate that uses derivatives and short plays. Both can go 100% long or short if need be. According to vice president and portfolio manager Kevin Kearns, the idea is to isolate the different sorts of risk from every bond-its interest rate risk, currency risk, credit risk and swap risk-and then hedge out some of the risks if need be by shorting.

For example, take a corporate bond like Russian mobile phone provider Vimpelcom. In this case, the company likes Vimpelcom's recent issuance of bonds maturing in 2021, which have a 7.748% coupon. On top of that Kearns must consider Russian sovereign risk. The fund doesn't want that Russian sovereign risk, so Loomis Sayles buys the U.S. dollar denominated bond and then hedges against U.S. interest rates.

"This is going to be dominated by U.S. interest rates because it's based on U.S. dollars etc.," he says. "From that perspective, we hedged out U.S. interest rates because we didn't want to take that risk. So what we're really looking for in this case is the credit spread to contract. If it contracts, then we've made a very good investment while not taking U.S. interest rate risk and not taking Russian risk."

Another example is Brazil, which, even though it has a strong economy with strong companies, has a more volatile currency, he says. "If you have a very volatile country, even though you might have a high coupon, your month-to-month return can be dominated by that currency," says Kearns. "So you have to ask as you construct the portfolio 'Do I want that additional volatility in the portfolio? What risk in that particular bond do I view as attractive?'"

No Thanks
Not everyone is convinced, however, that right now emerging market bonds are safe or good deals. Thornburg, for one, is staying away from the sector in its strategic income fund. The fund has a flexible mandate to go anywhere, but currently its managers don't like the emerging market debt picture at all.

"I would put us extremely negative on emerging market debt," says Strickland. "So we hold almost none within the fund-only a few relatively small 1%-2% positions in Brazilian debt that we put on a couple of years ago."

He says that in the long term he's bullish about these economies, but in the short term he's concerned about a number of factors. Though he likes Brazil, Indonesia, Turkey and Peru, he says that the spreads for dollar denominated debt in those countries are too low, some only 100 to 150 basis points over Treasurys.

There "has been the flood of cash flowing into emerging market funds," he says. "Global bond funds that don't have our flexibility can't avoid emerging market debt when it appears overpriced. This has created a situation where valuations have been bid up to levels and spreads have been compressed to levels where there is really no room for error."