Luz Padilla remembers a conference call in the late 1990s promoting a new issue of Indonesian corporate bonds as a very tiring event that took place in the wee hours of the morning and drew just three participants.

A follower of emerging market bonds since she began her career in the mid-1990s, the manager of the DoubleLine Emerging Markets Fixed Income Fund has seen the category blossom from a niche investment into a much-followed corner of the market. "Now, there can be hundreds of people listening in on an emerging market bond conference call," she says. "And thankfully, they take place during normal business hours."

Over a decade after Padilla's lonely encounter with Indonesia bond analysts, the world of emerging market bonds has undergone a complete facelift as emerging market countries and companies shake off their frontier image and gain new respectability. Once hotbeds for political unrest and rampant inflation, countries such as Brazil and Peru have taken steps to control those demons through government and banking reform, and investors have taken notice. Emerging market bond funds now have $186 billion in assets, and saw $54 billion in inflows during 2010 and over $14.8 billion so far this year, according to the EPFR Report.

In exchange for taking on emerging market risk, investors have enjoyed superior returns compared with most other types of fixed-income investments and even many stock markets. Over the last ten years, the Merrill Lynch EM Sovereign Index has achieved an annualized return of 11.03%, compared to 5.52% for U.S. Treasurys, 8.6% for U.S. high-yield bonds, and 2.64% for the S&P 500 index. The last year has been a particularly rewarding one for emerging market bond fund investors, who averaged a return of nearly 14%, according to Morningstar.

All this money pouring into emerging market bonds has pushed up prices and driven down yields relative to U.S. Treasury bonds and other developed market securities. Still, the 4.6% average yield on emerging market bond funds beats the 2.76% yield for taxable U.S. investment-grade bond funds tracked by Standard & Poor's by a considerable margin. And Padilla says there's room for appreciation, particularly at the corporate end of the market.

"This asset class will continue to deliver," she says. "Going forward, I believe high-single-digit returns in the corporate emerging market debt are very achievable."

Avoiding Sovereigns, Local Currencies
Recent inflows into emerging market bond funds have been the strongest in the local currency end of the market, which includes sovereign debt issued by local governments as well as corporate securities. Many investors are banking on an appreciation of local currencies against the dollar to increase investment returns.

But in a bold decision to eschew that popular strategy, Padilla has avoided local currency government and corporate bonds since the fund was launched in April 2010 and has focused almost exclusively on dollar-denominated securities. She has done so to skirt local currency risk, which she believes is still a very real threat in emerging markets for a number of reasons.

Inflation and policymaker attempts to control it through tightening interest rates and other measures top her list of concerns. "Inflation is taking hold in many emerging markets, and leaders have been aggressively addressing it, especially in the last 12 months," she says. "That is not good news for local currency bonds."

If there is a flight to safety, it won't necessarily be kind to emerging market currencies. When a similar mind-set took hold in 2010, she says, investors piled into the U.S. dollar and Treasury securities.

"I don't mind taking on the added volatility of local currency bonds if it means achieving better returns than dollar-denominated securities," she says. "But I don't think that's the case right now."

She also favors less-discovered corporates over sovereign bonds, and the fund's portfolio today has over three-quarters of its assets in dollar-denominated corporate securities. "As an asset class, sovereign debt has played itself out over the last ten years," she observes. "I would describe the valuations there now as fair to expensive."

Corporates also have an added kicker in the form of potential credit rating upgrades, a scenario that she believes has been largely played out in the government bond market. "Of course, there will be a continued improvement in country debt ratings, but at current valuations I think a lot of the good news has already been priced into the sovereign debt," she observes.

Although companies have improved their finances, there is still plenty of room for credit rating improvements. The fund, which has an expense ratio of 1.20%, has nearly half of its assets in investment-grade issuers, but most of that is clustered at the 'BBB' level, the lowest investment-grade rating given by Standard & Poor's.

Many investors have not woken up to the strong balance sheets and businesses that some emerging market companies offer. "One study shows that, across all rating tiers, emerging market corporate credits were less levered than their developed market counterparts, and that means they are on more solid financial footing," she says. "Many of these credits compare favorably to investment-grade companies in the U.S. Some of them are top ten players in the world markets. The only reason they're rated below investment grade is that they are domiciled in emerging market counties."

She compares the perception of corporate emerging market debt to where sovereign debt was a few years ago. "What we're trying to do is find corporate credits that can make the transition to investment grade, as a number of countries did. Seven or eight years ago, Russia was on the verge of default. Now, it's an investment-grade credit." In a few cases, such as Brazil's Petrobras, companies are achieving investment-grade status before their country of domicile.

Another lift comes from the stealth inclusion of emerging market corporate bonds in a number of benchmark indexes that many investment managers use to tailor their portfolios. Even though they hail from emerging markets, a number of EM companies have found their way into developed market indices because of their favorable financial profiles. Padilla says she's seen participation in these indices rise from 2% a few years ago to 10% now, and she expects the trend to continue as more issuers tap the debt markets. Some high-yield debt fund managers are also increasing their allocations to EM corporate bonds, she says.

To find bonds she likes, Padilla combines the credit analysis of a company with the economic outlook for its domicile country. In addition to a strong financial position, companies must have the ability to compete globally and operate in strategically critical sectors such as banking, natural resources, telecommunications and utilities.

She highlights leading Brazilian ethanol producer Cosan as a company that can enhance its financial position after a recent joint venture with Shell. As part of that agreement, the latter company agreed to assume much of Cosan's debt.

In Mexico, leading tortilla maker Gruma ran into trouble a couple of years ago after some ill-timed currency swaps. Recently, Padilla began buying its bonds after she determined its move to refinance its debt from the currency transaction at favorable terms would improve its financial position over the long term.

At just under 15% of assets, the fund's largest country weighting is Brazil, followed by Russia at 14% and Mexico at 13%. She has a 12% weighting in Peru, where she sees great strides in economic growth that should benefit the country's companies.

Chinese companies account for only about 5% of the fund's assets, even though they are very active in the high-yield market. Padilla says many of the companies in the region lack transparency and are involved in the bubble-prone property sector. She also steers clear of certain pockets in Latin America, such as Venezuela and Ecuador because of problems with government leaders.

Padilla also scrutinizes corporate leadership. For example, in May she passed on a new bond issue from TV Azteca, Mexico's second-largest broadcaster. In 2006, the company's chairman and its CEO paid more than $8.5 million to the Securities and Exchange Commission to settle charges that they profited from improper loan deals.

While the incident highlights the perception of corruption and the lack of transparency that deter some people from venturing into corporate emerging market bonds, Padilla argues that many companies in emerging markets have transparent balance sheets that are as clean as, if not cleaner than, similarly rated businesses in the U.S. and other developed markets.

Better reporting standards and the ability to access information through the Internet makes it relatively easy to follow emerging market company credits, she adds. After following emerging market companies since 1994, first as a credit analyst for TCW and later as the head of the firm's emerging markets fixed-income team, she has also gotten to know some of their managers well. In 2009, she took her expertise to new grounds when she followed former TCW star bond fund manager Jeffrey Gundlach to DoubleLine, the firm he founded after a controversial departure from his former employer.

Padilla is confident that investors will warm up to her independent management style and to emerging market bonds in general. DoubleLine and others recommend that investors have somewhere between 0% and 20% of their fixed-income portfolios in emerging market debt. Given current conditions, Padilla believes around 10% is appropriate.