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.