Last year, investors fed up with low yields on government bonds and certificates of deposit poured billions of dollars into real estate investment trusts, high-yield bonds, dividend-paying stocks and other income-generating assets. The downside of all the new money in these securities is that they now sell at higher prices, and thus rake in lower yields.

Given the dwindling number of income-generating bargains out there, James Swanson, lead manager of the MFS Diversified Income Fund and the chief investment strategist at MFS Investment Management, is understandably more enthusiastic about some parts of his portfolio than others. “We have a definite bias toward emerging markets,” says Swanson. “But at this point, there is not much value in the government or high-yield U.S. corporate debt markets.”

Bonds account for roughly half of the assets at Swanson’s fund. U.S. high-yield takes up the most space, 19.5% of assets, while U.S. government securities account for 17%. The fund also has dollar-denominated emerging market sovereign and corporate debt positions. At 15% of the portfolio, these are its smallest holdings, but the footprint has become bigger than usual.

Swanson is leaning toward emerging market bonds for a number of reasons. Many emerging market countries have become much more creditworthy and less risky. They have put in place prudent fiscal policies. They face only moderate inflation. And their GDP growth has been healthy over the last decade. The public debt averages only 30% to 35% of GDP in these countries, while it’s 80% to 90% in developed markets. Upgrades have meanwhile exceeded downgrades, offering a flip side of the deteriorating credit in the developed countries. The emerging markets’ yield spreads have risen to 280 basis points over Treasurys at the same time these countries have seen diminished volatility—two more factors that over the last few years have added to the appeal of these securities.

Furthermore, these bonds have become more stable because U.S. pension funds, mutual funds, endowments and other institutional investors have been participating more in these markets, adding stability to this once-volatile asset class.
“Emerging markets aren’t immune to global financial shocks,” says Matthew Ryan, who manages the emerging market bond sleeve of the MFS portfolio. “But the bonds don’t trade off as much as developed market bonds, and they tend to bounce back more quickly.”

Still, with the increased popularity of this asset breed, he admits that prices have moved from inexpensive to just “fairly valued” over the last year. To squeeze more value from the emerging market portion of the portfolio, which consists mainly of dollar-denominated sovereign debt, Ryan favors countries with healthy economies whose ratings could rise. The countries fitting that description in Latin America include Mexico, where issuers are benefiting from the country’s low debt-to-GDP ratio, its respectable 3.5% economic growth and its increased competitiveness in the global export markets.
He also likes Peru, whose 6% to 7% GDP growth makes it one of the region’s fastest-growing economies, one where an abundance of agricultural and mining resources supports that trend. On the other hand, he is less enamored of bonds issued by Argentina and Venezuela because of those countries’ sluggish economic growth.

In Europe, he likes the bonds of Latvia, a country whose substantial austerity measures and structural reforms have ushered in positive economic growth and a recent rating upgrade. He also likes Turkish bonds. Turkey was recently upgraded by Fitch to investment-grade status. The country faces geopolitical problems with its proximity to Syria and Iraq.
But it also boasts a number of strengths, such as a small but well-capitalized banking system, low debt and bonds that yield about 200 basis points more than U.S. Treasury securities, and these factors overshadow the downside in Ryan’s mind.

The MFS fund’s corporate bonds include those issued by the oil producer Afren, whose reserve assets are located mainly in Africa. Ryan says the company has experienced solid revenue growth, high profit margins and declining leverage.
Another holding is Canadian copper miner First Quantum. The assets of this company include mines in Zambia, one of the more politically stable countries in Africa. Its bonds, which mature in 2019, sport a yield premium of nearly 600 basis points over Treasurys.

Even though the fund has put an increasing emphasis on emerging-market debt, Swanson says the U.S. government securities portion is still very important, because it adds some ballast against any possible political or economic catastrophes overseas. But the negative real returns of these domestic bonds after inflation “make them very expensive paper for the long run.” Inflation and rising interest rates, which seem inevitable these days, tend to hit government bonds harder than others, one reason he’s keeping that part of the portfolio in check.

“There are a couple of things holding back inflation for the time being,” he says. “The demand for goods has not bumped up against supply constraints, which makes it hard for companies to raise prices. And because the unemployment rate is still relatively high, wage inflation hasn’t kicked in. But that could change later this year as the unemployment rate falls and demand for goods increases.”

He’s also not adding to the U.S. high-yield sleeve because the prices in that space aren’t attractive. And he fears that if a recession sparks a move to safer investments, it will drag junk bond prices down.

None of this is to mention the stock side of the MFS portfolio, which accounts for roughly 40% of assets. These are divided about equally between dividend-paying value stocks and real estate investment trusts. Swanson says the latter have experienced strong cash flow from rents, and he believes the sluggish building and a limited supply of new space have set the stage for stable or rising revenues in the REIT market. Overbuilding, which typically occurs several years after the real estate market has bottomed out, hasn’t happened yet.

Still, with REITs trading at 17 to 18 times cash flow, which is high by historic standards, the stocks have become pricey. And the yields have fallen from a historic average of 6.5% to about 3.5%, which could dim their appeal. But Swanson is keeping a foot in the door here as an insurance policy against inflation. “REITs are a financial proxy for hard real estate, which tends to do well in inflationary times,” he says. “They’re a way to generate good yields from a group with limited downside risk.”

He’s more enthusiastic about the values of the fund’s dividend-paying value stocks, whose prices he describes as “fair, but not super cheap.” With bond yields so low, investor interest in dividend stocks remains strong, and strong corporate cash flows should help ensure that the payouts will keep up with inflation. There is some cause for concern that taxes on dividends will rise, which could hurt these securities. But Swanson says he’s optimistic that Congress can overcome its partisan bickering and work together to keep these taxes in check.

More important, he says, than who wrestles control of the tax issue in Congress are the predictable ebb and flow of business cycles and the effect they have on economic growth and the stock market. “We are about three years into the economic recovery, and we see the recovery phase of the business cycle lasting another two or three years,” he says. “The end of the expansion phase is usually marked by the Fed raising interest rates and greater use of credit, which haven’t happened yet.”

Swanson won’t forecast where the stock market will be by the end of the year, but historical precedents indicate there is room for further growth, he thinks. “Since the market bottom in 2009, the stock market has climbed about 90%. By this stage of an economic recovery, stocks have historically risen 120% from the bottom.”

To capitalize on that growth, the fund is adding to positions in companies with cheaper valuations than their competitors have, with strong financial characteristics and prospects for good earnings growth.

Jonathan Sage, who selects value stocks for the portfolio, cites ExxonMobil as one such company. The stock’s 2.6% dividend yield and active stock buyback program add value for investors, while the company’s revenue stream from diversified businesses such as chemicals, gas and oil make it a more defensive play than its competitors, who focus solely on oil.

Another attractive play is big pharma company Pfizer, whose stock price has been driven down by investors concerned about its expiring patents and disappointing earnings reports. The prices have fallen to a very attractive 10.5 times forward 12-month earnings, while Pfizer’s peers in the pharmaceutical group carry a price of 13 times to 16 times earnings. Sage meanwhile calls Pfizer’s product pipeline “underappreciated,” and he likes the company’s active stock buyback program and its juicy 3.6% dividend yield. He also believes Pfizer could realize cost savings if it can pull off its plans to divest from its nutritional and animal health divisions this year.

While the MFS fund focuses mainly on larger company stocks, it also owns a number of mid-cap names such as property and casualty insurer Validus Group.